Balance Sheet Analysis: The 4 Essential Points to Know

Welcome to this chapter on balance sheet analysis!

In this Operational Management course, we will see the 4 essential characteristics for complete mastery of balance sheet analysis.

Concretely, here are the different points that I will cover in this course:

• Analysis of the accounting balance sheet
• Functional assessment analysis
• Financial balance and functional balance sheet
• Functional balance sheet ratios
• Conclusion

 

Analysis of the accounting balance sheet

What is a balance sheet?

The balance sheet is a financial statement that shows the situation of the assets of the business unit at a given time. It specifies the assets, i.e. what it owns, and the liabilities, what it owes, of the company. It is established for a 12-month accounting period.

The balance sheet is composed of two main parts: assets and liabilities. According to the double-entry accounting principle, the balance sheet must be balanced at the level of the totals of the “Net” Assets and Liabilities columns.

The total assets in the “Net” column are equal to the total liabilities in the “Net” column.

In the balance sheet there is a section which is identical to that found in the income statement: this is the item Profit for the financial year.

Here is the structure of a balance sheet:

 

What are the balance sheet items?

The liabilities of the balance sheet

On the liabilities side, there are two columns: one for the labels and a second for the amounts.

 Liabilities correspond to all of the company's debts.

It is made up of the resources available to the company, i.e. all of its debts. It is broken down as follows:

• Equity
  • the capital
  • reserves
  • the result of the exercise
  • carry forward (RAN)
• Provisions
  • provisions for risks
  • Provisions for charges
• The debts
  • loans
  • supplier debts
  • tax and social security debts
  • other debts

Here is an example of a balance sheet – Liabilities

 

The assets of the balance sheet

On the assets side, there is a label column and three amount columns.

The assets of the balance sheet correspond to all the goods owned by the business unit.

It brings together all the elements held by the company and is presented in three columns of amounts: Gross, Depreciation and provisions, Net.

The “Net” column is equal to the difference between the “Gross” column and the “Depreciation and Provisions” column.

 

Fixed assets :

These are assets held by the company for more than a year. These are called fixed assets. We can distinguish:

Intangible assets :

These are mainly patents, licenses and trademarks, establishment costs, research and development costs (RDC). These are non-tangible elements.

 

Fixed assets :

This includes furniture, computers, vehicle fleet, machines, etc.

 

Financial fixed assets :

These are loans and investments, deposits and guarantees.

 

Current assets :

This is the set of elements that are in perpetual motion, and which consequently do not remain in the company for more than a year.

• Stocks of goods, miscellaneous stocks.
• Trade receivables, miscellaneous receivables.
• Investment securities (VMP): these are securities held for the sole purpose of making short-term capital gains.
• Availability: Bank, Cash and CCP positions

 

Depreciation

This is the observation of the depreciation of the fixed assets of the balance sheet.

The calculation takes into account several elements: the acquisition cost excluding tax, the depreciation rate, the lifespan of the asset.

Depreciation = VO x rate x pro rata

 

The provision

This is the observation of the depreciation of the elements of the current assets of the balance sheet. This therefore concerns stocks, receivables and VMP.

A potential loss rate is applied to assess the amount of the provision.

 

Here is an example of a balance sheet – Assets:

 

 

Functional assessment analysis

What is a functional assessment?

This is not a second accounting balance sheet. The purpose of the functional balance sheet is to be able to carry out a financial analysis of the company. It takes the elements of the accounting balance sheet but these are reorganized into large masses. It is established from the accounting balance sheet.

 

The large masses of the functional balance sheet

In the functional balance sheet we no longer speak of Assets and Liabilities, but of Jobs and Resources. These are at the origin of the creation of the company. They are used to finance Jobs.

 

At the resource level

Stable Resources

• Equity
• Long term debts
• Provisions for risks and charges
• Total of the column Depreciation and provisions of the assets of the balance sheet

 

Circulating resources

 

Operating circulating resources

• Supplier debts
• Tax and social security debts (VAT, URSSAF, social security, etc.) (according to statement)

 

Non-operating circulating resources

• Other debts
• As stated

 

Circulating resources =
Operating circulating resources + Non-operating circulating resources

RC = RCE + RCHE

 

Treasury Passive

These are bank loans and bank credit balances.

You have been warned! : SCBs are often initially found in long-term debts or financial debts. Read carefully any references found at the bottom of the balance sheet.

 

At the employment level

stable jobs

This is the set of fixed assets in raw values.

 

Circulating jobs

This is the current asset in gross values ​​excluding the Cash and Cash equivalents item.

 

Circulating exploitation jobs

• Stocks of goods
• Receivables
• VMP (as stated)

 

Non-operating circulating jobs

• Miscellaneous stocks
• Miscellaneous receivables
• VMP (as stated)

Circulating jobs =
Current operating jobs + Current non-operating jobs

EC = ECE + ECHE

 

Treasury Assets

This is the Availability item which includes the following sections: Bank, Cash, CCP.

 

What is the structure of the functional balance sheet?

A functional balance sheet consists of two major parts: uses and resources. It also highlights the different economic cycles of the business unit, namely the investment cycle, the financing cycle and the operating cycle.

I wrote a management course on the operating cycle if you want to know more about this chapter.

Here is an example of a functional balance sheet:

Careers	Resources
Stable jobs	Stable Resources
Operating circulating jobs	Operating circulating resources
Non-operating current jobs	Non-operating circulating resources
Cash assets	Liability cash
GRAND TOTAL	GRAND TOTAL

 

 

Financial balance and functional balance sheet

In order to analyze the functional balance sheet, it is necessary to know and apply the following major balances:

 

Net working capital (NWC) = Stable resources – Stable jobs

 

Working capital requirement (WCR) = Current operating uses – Current operating resources

Non-operating working capital requirement (BFRHE) = Non-operating current assets – Non-operating current resources

Working capital requirement (WCR) = BFRE + WCRHE

 

Net cash (TN) = FRNG – BFR

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Net Cash (NC) = Cash Assets – Cash Liabilities

If you want to know more about net cash flow, I invite you to go to debit-credit.fr who wrote a dedicated article on the subject.

 

Results interpretation

If the FRNG is positive, it means that the company has sufficient stable resources to finance its fixed assets. These are therefore properly financed.

If the BFR is positive, this means that the company has not been able to negotiate short collection periods with its customers and long periods with its suppliers.

This positive amount is due to the lag between receipts and disbursements. This implies that the company repays its supplier debts before collecting its customer receivables.

The interpretation of the TN is the consequence of the previous results.

If the TN is positive it means that the FRNG is greater than the BFR.

If the TN is negative it means that the BFR is greater than the FRNG.

 

The 5 financial balance situations to know

FRNG	BFR	TN	Financial Balance Respected
+ Positive	+ Positive	+ Positive	Yes S1
+ Positive	+ Positive	- Negative	Yes S2
- Negative	- Negative	- Negative	No S3
+ Positive	- Negative	+ Positive	Yes S4
- Negative	+ Positive	- Negative	No S5

 

Interpretations and explanations:

Financial Balance Respected	Explanations (calculation of TN)
Yes S1	1 - 000 = 800 The FRNG is positive. The financial situation is healthy.
Yes S2	1 - 000 = - 3 The business unit has a bank credit balance (overdraft). It pays bank charges and third parties do not trust it.
No S3	- 1 - (-000) = - 300 The situation absolutely must be restored because the FRNG is negative, as is the cash flow.
Yes S4	1 - (-000) = 800 The financial situation is healthy and very favorable because the WCR is positive (=RFR).
No S5	- 1 - 000 = - 600 The financial situation is very critical. The FRNG must be restored. The bank of the business unit is charging bank charges because the net cash is negative.

 

Balance sheet analysis: Functional balance sheet ratios

Turnover ratios :

 

Average duration of customer credit = (Accounts receivable / turnover including tax) x 360 days

It measures the average duration in days of credit granted by the company to its customers. It is preferable that the duration is as short as possible.

Example: On average, the business unit's customers pay off their debt every 35 days.

 

Average duration of supplier credit = (Supplier Debts / Annual Purchases including VAT) x 360 days

It measures the average duration in days of credit obtained by the company from its suppliers. It is preferable that it is higher than the customer credit ratio.

Example: On average, the business unit repays its debts every 38 days.

 

Average storage duration = (Average inventory / Cost of goods sold) x 360 days

With average stock = (initial stock + final stock) / 2

It measures the duration of inventory flow.

Example: On average, the business unit's goods are stored for 19 days before being sold.

 

Other significant ratios

Financing ratios = Stable resources / Stable jobs

It measures the coverage of stable jobs by stable resources. If the ratio is greater than 1, it means that stable resources are sufficient to finance stable jobs.

 

Rate of endettement = Borrowed capital / Equity capital

It measures the degree of indebtedness of the company. If the ratio is greater than 1, it means that the company is over-indebted.

 

Conclusion

The business unit must verify and understand the balance of the functional balance sheet. This involves mastering the financial balance situations that it may encounter. It must also be able to rectify the situation if the ratios of its functional balance sheet are not in its favor.

If you want to apply everything you have just learned, I strongly encourage you to read my article on corrected management exercises entitled Functional assessment: 16 corrected exercises.

There you go, now you know how to do the balance sheet analysis. You no longer have any excuses for not reaching your goal: Get an excellent grade in the Operational Management test!