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How To Evaluate A Companys Balance Sheet
For stock investors, the balance sheet is an important consideration for investing in a company because it is a reflection of what the company owns and owes. The strength of a companys balance sheet can be evaluated by three broad categories of investment-quality measurements:working capital adequacy, asset performance and capitalization structure.
Tutorial: Financial Statement AnalysisIn this article, well look at four evaluative perspectives on a companys asset performance: (1) the cash conversion cycle, (2) the fixed asset turnover ratio, (3) the return on assets ratio and (4) the impact of intangible assets.
The Cash Conversion Cycle (CCC)
The cash conversion cycle is a key indicator of the adequacy of a companys working capital position. In addition, the CCC is equally important as the measurement of a companys ability to efficiently manage two of its most important assets - accounts receivable and inventory.
Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter this cycle is, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than tying up unproductive working capital in assets.
CCC = DIO DSO – DPO
DIO - Days Inventory Outstanding
DSO - Days Sales Outstanding
DPO - Days Payable Outstanding
There is no single optimal metric for the CCC, which is also referred to as a companys operating cycle. As a rule, a companys cash conversion cycle will be influenced heavily by the type of product or service it provides and industry characteristics.
Investors looking for investment quality in this area of a companys balance sheet need to track the CCC over an extended period of time (for example, five to 10 years), and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in inventory on hand are generally not positive investment-quality indicators. (To read more on CCC, see Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.)
The Fixed Asset Turnover Ratio
Property, plant and equipment (PP
