How Investment Bankers Can Use the Balance Statement to Gauge a Company's Financial Strength - dummies

How Investment Bankers Can Use the Balance Statement to Gauge a Company’s Financial Strength

By Matt Krantz, Robert R. Johnson

The balance sheet for an investment banker serves a similar role as blood work for a doctor. When you go to the doctor, and blood is drawn, the physician gets a current snapshot of your health. The blood work tells the doctor more about long-term trends or attributes about your health. Similarly, investment bankers use the balance sheet to get a broad view of the health of a company.

If a company just released a hit product, it may be posting huge profits and the income statement may show the numbers of a highly successful company. But not until the company finds a way to extract that profit and put it in the bank or invest it do those riches show up on the balance sheet.

The primary way investment bankers pull apart the financial statements is by using financial ratios. But there are ways to glean insights into a company’s financial health just using the balance sheet, including the following:

  • Common sizing analysis: One of the key weapons of investment bankers is the technique of common sizing, a type of financial analysis that measures all the elements of a financial statement relative to the total. When common sizing the balance sheet, all the company’s individual assets are divided by the total assets and each of the individual liabilities are divided by the total assets, too.

    This seemingly simple exercise can quickly put a company’s balance sheet into perspective.

    An investment banker would look at this common size analysis, and several things would immediately jump out. First, notice that 15 percent of the company’s total assets are held in cash. An investment banker may wonder if there might be better uses for that cash than sitting idly collecting interest.

    Another takeaway is that 35 percent of the company’s assets are tied up in property, plant, and equipment. This indicates that the company is pretty capital intensive, meaning large investments in equipment are needed to compete.

    Balance Sheet Line Item 2012 Value ($ millions) Common sized Value
    Cash and equivalents $728.3 15.3%
    Accounts receivable $461.4 9.7%
    Inventories $633.3 13.3%
    Property, plant, and equipment $1,674.1 35.2%
    Goodwill $588.0 12.4%
    Other assets $669.70 14.1%
    Total assets $4,754.8 100%
    Accounts payable $442.0 9.3%
    Short-term debt $118.2 2.5%
    Current portion of long-term debt $257.7 5.4%
    Long-term debt $1,531.0 32.2%
    Other liabilities $1,357.6 28.6%
    Total liabilities $3,706.5 78%
    Total equity $1,048.4 22%
  • Comparing debt to equity: One of the most telling exercises for investment bankers looking at the balance sheet is the relationship between a company’s total debt and its equity. By dividing a company’s total liabilities by its total equity, investment bankers can see how leveraged a company is, or how much of the cost of the company’s assets are financed using debt and how much are financed using equity.

    Using the Hershey example, investment bankers see that the company relies much more heavily — more than three times more — on borrowings than on equity. Knowing this will help guide the investment bankers offering solutions to the company.

  • Studying book value: A company’s book value of equity, loosely speaking, is much like a person’s net worth. The book value of equity of a company is a rough estimate of what the company’s collection of assets is worth after paying all its liabilities. The key assumption, here, however, is that assets are liquidated at book value and liabilities are extinguished at book value.

    In reality, some assets, such as land, may be worth much more than book value, and other assets, such as inventory, may be worth much less than book value. Book value of equity is calculated by subtracting total liabilities and goodwill from a company’s total assets.

    Book value is roughly designed to give investors an idea of what a company would be worth if all its assets were liquidated (sold off ). That’s one reason why goodwill is excluded from book value, because goodwill is an intangible asset and can’t be easily sold separately. Some investors look for undervalued companies by looking for where stock prices are below a company’s book value.