lecture2_balance sheet analysis_to be printed

7/26/2019 Lecture2_Balance Sheet Analysis_to Be Printed

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Balance Sheet Analysis


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The balance sheet is a snapshot of the firms

assets and liabilities at a given point in time

Assets are listed in order of liquidity

Ease of conversion to cash

Without significant loss of value

Balance Sheet Identity

Assets = Liabilities + Stockholders Equity


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To remember. . .

Basic equationsAssets = Debt + Equity

Assets minus debts = equity

Assets - equity = debt


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The Balance-Sheet Model

of the Firm

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders

Equity

Current

Liabilities

Long-Term

Debt

Investmentdecision

The Capital Budgeting Decision

Financing

decision

Workingcapital

management


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There is a

financialequilibriumbetweenresources andtheir uses?

Net

WorkingCapital

Shareholders

Equity

Current

LiabilitiesCurrent Assets

Fixed Assets

1 Tangible

2 Intangible

Long-Term

Debt

Balance Sheet Structure


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Current Assets

cash, marketable securities, inventory,

accounts receivable

Long-Term Assets

equipment, buildings, land

Which earn higher rates of return?

Which help avoid risk of illiquidity?



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Current Assets

cash, marketable securities, inventory,

accounts receivable

Long-Term Assets

equipment, buildings, land

Risk-Return Trade-off:

Current assets earn low returns, but help reduce

the risk of illiquidity.



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Current Liabilities

short-term notes, accrued expenses,

accounts payable

Long-Term Debt and Equity bonds, preferred stock, common stock

Which are more expensive for the firm? Which help avoid risk of illiquidity?



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Current Liabilities short-term notes, accrued expenses,

accounts payable

Long-Term Debt and Equity

bonds, preferred stock, common stock

Risk-Return Trade-off:Current liabilities are less expensive, butincrease the risk of illiquidity.



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Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

To illustrate, lets finance all current assetswith current liabilities, and finance all

fixed assets with long-termfinancing.


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Balance Sheet

Current Assets CurrentLiabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

Suppose we use long-term financing to

finance some of our current assets.

This strategy would be less risky, but more

expensive!


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Balance Sheet

Current Assets Current Liabilities

Fixed Assets

Long-Term Debt

Preferred Stock

Common Stock

Suppose we use current liabilities to financesome of our fixed assets.

This strategy would be less expensive, butmore risky!


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Permanent Assets (those held > 1 year)

should be financed with permanent and

spontaneous sources of financing

Temporary Assets (those held < 1 year)

should be financed with temporary sources

of financing

The hedging principle


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Two Basic Questions:

1. What is the appropriate level for

current assets, both in total and byspecific accounts?

2. How should current assets befinanced?



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The Requirement for Current

Assets Financing depends on: Seasonal Variations

Business Cycles

Expansion of the companysactivity


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Permanent cu rrent assets

TIME

DOLLA

R

AMOUNT

Tempo rary current assets

Current Assets


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Current Assets

Permanent Current AssetsCurrent asset balances that do not change

due to seasonal or economic conditions--even at the trough of a firms business cycle

Permanent Current Assets


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Temporary Current Assets

Current assets that fluctuate with seasonal

or economic variations in a firms business

Current Assets

Temporary Current Assets


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Alternative Current Asset

Financing Policies

ModerateMatch the maturity of theassets with the maturity of the financing.

AggressiveUse short-term financing tofinance permanent assets.

ConservativeUse permanent capital for

permanent assets and temporary assets.


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Maturity Matching, or

Self-Liquidating ApproachA financing policy that matches assetand liability maturities

This would be considered a moderate

current asset financing policy


Financing Policies


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Hedging (or Maturity

Matching) Approach

A method of financing where each asset would be offset with a financing

instrument of the same approximate maturity.

TIME

DOLLA

R

AMOUNT

Long-term financing

Fixed assets

Current assets*

Short-term financing**


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Conservative Approach

A policy where all of the fixed assets,

all of the permanent current assets, and

some of the temporary current assets of

a firm are financed with long-term

capital


Financing Policies


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Risks vs. Costs Trade-Off

(Conservative Approach)

Firm can reduce risks associated with short-term borrowing by using a

larger proportion of long-term financing.

TIME

DOLLA

R

AMOUNT

Long-term financing

Fixed assets

Current assets

Short- term financing


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Aggressive Approach

A policy where all of the fixed assets of

a firm are financed with long-term capital,

but some of the firms permanent current

assets are financed with short-term non-

spontaneous sources of funds


Financing Policies


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Firm increases risks associated with short-term borrowing by using a

larger proportion of short-term financing.

TIME

DOLLA

R

AMOUNT

Long-term financing

Fixed assets

Current assets

Short-term financing

Risks vs . Cos ts Trade-Off

(Aggressive Approach )


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Summary of Short- vs.

Long-Term Financing

Financing

Maturity

AssetMaturity

SHORT-TERM LONG-TERM

Low

Risk-Profitability

Moderate

Risk-Profitability

Moderate

Risk-Profitability

High

Risk-Profitability

SHORT-TERM

(Temporary)

LONG-TERM

(Permanent)


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Quick Quiz What is the balance-sheet equation?

What is the difference between Romanian Form and Anglo-Saxon Form of thebalance sheet?

Which things should be kept in mind when looking at a balance sheet?

Which is the most important piece of information we have to look for in abalance sheet, as stockholders (creditors, or other stakeholders)?

How should current assets be financed?

Which are the implications of financing short term assets by long termresources?

Which are the implications of financing long term assets by short termresources?

Conservative or Aggressive Financing Policy? Which one are you inclined touse? Why?

How do you see the situation of an en-detail trading company, which has anegative net working capital?

QuickGrow is in an expanding market, and its sales are increasing by 25percent per year. Would you expect its net working capital to be increasing ordecreasing?

Why do you think one would need market values in the financial analysis of thebalance sheet?

lecture2_balance sheet analysis_to be printed

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