120: How to Read a Balance Sheet Like A CFO

Join me on this enlightening episode, where I dive into the cornerstone of financial analysis: the balance sheet. As a CFO with years of experience navigating financial landscapes, I am taking you on a guided tour through the intricate world of financial statements.

In this episode, I strip away the complexity surrounding balance sheets and reveal the essential insights every business leader should grasp. From deciphering assets and liabilities to understanding shareholder equity, I am breaking down each component with clarity and real-world examples.

Whether you're a seasoned entrepreneur, a budding investor, or simply curious about financial fundamentals, this episode equips you with the knowledge to confidently interpret a balance sheet. Learn how to spot financial health indicators, assess risk, and make informed decisions that drive your business forward.

Tune in as I share insider tips and practical advice gleaned from years at the helm of financial strategy. Gain a CFO's perspective on reading between the lines of balance sheets and harness this essential skill to empower your financial acumen.

Don't miss out on this enriching conversation that promises to demystify the balance sheet and elevate your understanding of corporate finance. Whether you're at the helm of a startup or steering a multinational corporation, mastering the balance sheet is key to navigating the financial waters with confidence.

Here's how to get started with Boosting Your Financial IQ:

• Step 1:  Test your financial IQ for FREE
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• Step 3:  Take the Fundamentals of Finance course

Disclaimer:
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Transcript

Speaker 1: 0:15

So in this episode, we'll explore how to read a balance sheet like a CFO, and I'll share some secret hacks to maximize your analysis. This is Boosting your Financial IQ, where I help business professionals with financial responsibility to elevate their careers and run profitable companies. My hope is that you'll apply these lessons to achieve your greatest ambitions. Cheers and enjoy what's up. My friend, last week, I walked you through how to read an income statement like a CFO, and in this episode, I'm going to teach you how to read a balance sheet in like manner. I'm going to provide you with some expert tips and then, at the end, I'm going to reveal some secret hacks that you're not going to want to miss. So stay tuned. Now, a balance sheet is not as scary as it seems. In fact, it's a financial statement that provides a snapshot of a company's financial position at a specific point in time, and that's really important to understand. A balance sheet is pulled as of a certain date, whereas the income statement and statement of cash flows is pulled over a period of time. Now, think of it like this If I said to you how much cash did you have between January and March In other words, what was your cash balance between this time. You would say okay, steve, are you talking about, like my average balance, or are you talking about the median balance? What are you talking about here? And the same thing is true with the balance sheet, just like with your bank statement, just like with your bank account. You're looking at what is your balance as of a certain date. The same thing is true with the balance sheet. You say, okay, how much cash did I have on this day, how much did I have in accounts receivable or accounts payable as of a certain date? With an income statement and statement of cash flows, you may wonder how much did I do in sales between April and June? And you can pull a statement in that manner, but a balance sheet? Don't ever ask somebody to pull a balance sheet between March and September, because that'd just be weird. Instead, you would say can you pull me a balance sheet as of September 30th, 2024 or whatever? It is All right. So that's something very important to understand. Now, unlike the income statement which we talked about last week, which tells you how much a company does in revenue, cost of goods sold, gross margin, operating expenses and, ultimately, profit, a balance sheet instead details what a company owns, their assets, what it owes, its liabilities and the equity held by its shareholders. Understanding how to read and interpret a balance sheet like a CFO can give you deeper insights into a company's financial, health and strategic potential. So in this episode, we'll explore how to read a balance sheet like a CFO and I'll share some secret hacks to maximize your analysis. So let's go ahead and dive right in Now.

Speaker 1: 3:07

First, you need to understand the structure of the balance sheet. Now, if you're like me and you're a visual learner, I like to see things up on a board. Guess what I got? Really good news for you, because on my YouTube channel at Steve Coffin you can go there I've been uploading videos that will walk you through how to read financial statements, and it'll get you started in this area. So be sure to check out my YouTube If you want to deepen your knowledge in this area. Now, if you want to take things to the next level, if you're an entrepreneur or you're a business leader or you want to be really successful in business, you can always go to byfiqcom, which stands for boosting your financial IQ. You could test your financial IQ there. There's an assessment on the homepage, and then you can also join a program, and this is where you'll take things to a whole new level in your life. All right, but those are two resources that you could check out. Definitely, check out my YouTube, like I said, because those videos are long form and I'm drawing on a whiteboard for you so you can understand how this all flows together. But in the meantime, let me provide you with some helpful tips to get going with the balance sheet.

Speaker 1: 4:17

Let's talk about structure. The balance sheet is divided into three main sections assets, liabilities and equity. That's the accounting formula Assets, equal liabilities plus equity. Let's start with assets. These are resources that are owned by the company, that have economic value. Assets are typically classified into current assets cash accounts, receivable, inventory prepaids, et cetera and non-current assets property, plant equipment and intangible assets. The only difference between current and non-current is essentially that current means it's due and payable or collectible within a 12-month timeframe, right? So that's the only difference there.

Speaker 1: 5:02

Let's move on to liabilities. Liabilities are obligations that a company must pay in the future. Liabilities are classified into current liabilities, such as accounts payable, payroll liabilities, short-term debt, et cetera, and non-current liabilities, such as long-term debt and deferred tax liabilities. And then there's equity, also known as shareholder equity. This represents the owner's claim after all liabilities have been paid. It includes common stock, retained earnings and additional paid in capital.

Speaker 1: 5:36

Now, equity was one of those categories in business school that was kind of confusing at first. So let me just explain it very simply. I wish my professors would have just broken it down in like manner. So let me just explain Equity is essentially the money you put into the business. Okay, so if you're an investor or you're an owner and you put capital into your company to start it or you raise capital, that's money in, that goes into equity, and then it's money flowing out through distributions. So equity is really just money that investors put in. It's all your retained earnings that you've earned over time. It's all your net income and then it's money that you take out through dividends or distributions. Okay, so that it's really simple. It doesn't have to be overly complicated.

Speaker 1: 6:24

Like I said, the basic equation of the balance sheet is assets equal liabilities plus equity. That's how the balance sheet balances. And if you ever look at a balance sheet and assets don't equal liabilities plus equity, that is called an unbalanced sheet and there's probably fraud. It's like Enron back in the day. Enron was a company that blew up under a huge fraud scandal. One of the biggest red flags in the whole process of imploding was that during investor calls, enron couldn't produce a balance sheet. And one time there was an analyst. He was on an investor call and he said how can you not produce a balance sheet? And the CEO of Enron, jeff Skilling, responded, not so kindly, by calling the analyst an a-hole. But that definitely would be a red flag if a company was unable to produce a balance sheet, and especially if the balance sheet didn't balance. Okay, so that's number one. That's just the structure produce a balance sheet, and especially if the balance sheet didn't balance. Okay, so that's number one. That's just the structure of the balance sheet.

Speaker 1: 7:25

Let's talk about focusing on key metrics. As a CFO, I had to pay close attention to specific metrics on the balance sheet that indicated the financial health and stability of the company. Here's some crucial ones, but there are a ton of metrics that I'm not going to cover, but here are some basic ones just to get you started. First is current ratio. This measures a company's ability to pay its short-term obligations with its short-term assets. The higher the ratio indicates better liquidity. It's calculated by taking current assets and dividing it by current liabilities. So when I look at a balance sheet, the first thing I do is I'll look, taking current assets and dividing it by current liabilities. So when I look at a balance sheet, the first thing I do is I'll look at current assets and then I'll look at current liabilities and if current assets are more than current liabilities, that means that the company is likely liquid and they're able to cover their obligations. That's where the current ratio is super valuable.

Speaker 1: 8:16

You want a ratio higher than one. The quick ratio is just like the current ratio, but you just take out inventory, because inventory is not so liquid. But inventory is a current asset, so it's up above in the current ratio. But in the quick ratio you're excluding inventory from the calculation. So think about Home Depot. They have a ton of inventory on their shelves, but that inventory is not going to be converted into cash until you pull it down off the shelf and then sell it to customers. So you could be tricking yourself as far as your ability to cover your short-term obligations if you have inventory in there. So that's why the quick ratio is a little bit more beneficial than the current ratio.

Speaker 1: 9:04

You also have the debt to equity ratio. This measures the proportion of debt and equity financing used by the company. A higher ratio indicates more leverage and potentially higher financial risk. The formula is total liabilities divided by shareholders' equity. There is also return on equity, also known as ROE. This measures the profitability relative to shareholders' equity. A higher ROE indicates efficient use of equity capital. The formula is net income, which comes from the income statement, divided by shareholders' equity.

Speaker 1: 9:36

All right, so those are just some key metrics that you could get started with. Every company is different, every industry is different, but these are a few just to help you get going in this direction. So that's number two, what I do, so I understand the structure and then I focus on key metrics. And then the third thing I do as a CFO is analyze trends over time. Examining balance sheets over multiple periods to identify trends and changes in a company's financial position is super helpful. Now here are a few trends that you can look at. First, you can compare periods. You can look at balance sheets from different quarters or years to see how assets, liabilities and equity have evolved. This may help you to understand growth patterns and identify potential issues. Next, you can calculate growth rates. You can determine growth rates for key items such as total assets, total liabilities and equity, which then provides insight into a company's financial trajectory. And last, you can assess consistency. You can check consistency in key ratios like the current ratio and the debt to equity ratio, which we just talked about. Over time, if you have significant fluctuations, this may require further investigation. This will help you to narrow your focus and help you to identify areas to go after where there is the biggest upside for improvement.

Speaker 1: 11:06

All right, so number four is dig deeper into asset and liability categories. So CFOs go beyond the surface to understand components of assets, liabilities and equity, and the same thing is true with what I was doing. So here's how. First, I'll look at asset quality. I like to evaluate the quality of assets by examining their liquidity and their potential risks. For instance, accounts receivable or the money that customers owe a company should be assessed for collectability, and inventory should be checked for obsolescence. In other words, you may be sitting on collectability and inventory should be checked for obsolescence. In other words, you may be sitting on a bunch of inventory that can't be sold or it's spoiled or whatever it may be, and therefore you may have to make some adjustments on your financial statements. So, evaluating the quality of assets is really really critical.

Speaker 1: 11:57

Next, there's liability structure. By analyzing the structure and maturity of liabilities, you'll be able to identify areas for improvement. Short-term liabilities should be manageable with current assets and long-term debt should be sustainable given the company's cash flow. So you have to understand the company's debt structure and whether or not the business is in a position to cover such debt. And then, lastly, evaluating capital expenditures, also known as CapEx, is really really critical. You do this by looking at non-current assets to understand the company's investments in property, plant and equipment. This will indicate the level of capital expenditure and potential for future growth. Now, CapEx and working capital is really important to monitor.

Speaker 1: 12:47

I'm not going to get into it in this episode, because just a few episodes back, I dedicated episodes specific to these topics. If you haven't listened to those episodes, make sure you go back in time and digest that content, because it's going to be really important to your financial IQ. Also, like I said, check out my YouTube videos, because I just dropped some really cool episodes where I walk you through how to compute cashflow, and CapEx is an important part of determining cashflow. All right, lastly, before I get into the hacks, I like to use benchmarking for context. So, as a CFO, I've used benchmarking to compare the company's performance that I'm running against its competitive set. So looking at the industry and the competitive set will help you to identify strengths and weaknesses in financial performance and position.

Speaker 1: 13:40

So here's some tips. First, look at industry averages. Compare key ratios and metrics such as the current ratio, quick ratio, debt to equity ratio against industry averages. This helps gauge the company's financial standing relative to competitors. Now, if you are a private company and you're listening to this and you don't know where to get this data, well, first you could go on to a site like Google Finance or Yahoo or Bloomberg, wherever you pull information on public companies, and you could look at ratios within your industry for public companies. Now, this is a good starting point, but it may not be granular or relatable enough for your company and therefore I would recommend working with an expert who works with other companies in your space and they'll be able to provide you with more detailed, granular benchmarking information. So I have access to proprietary data because I work with so many companies and therefore, if you ever need help with benchmarking or you want to do a financial analysis for your business, you could always reach out to me. You could connect at coltabarcom, just hit me up and we can talk through that. And lastly, regarding benchmarking, identifying best practices from leading companies in the industry that you're competing in will help you to identify your company's financial strategy and whether or not it's working and how you can improve your financial health. All right, and how you can improve your financial health, all right.

Speaker 1: 15:08

Now let's move on to some secret hacks for advanced analysis. I know it sounds so mysterious here, but to truly analyze a balance sheet like a CFO, here are some secret hacks for advanced insights. Number one common size analysis. So, just like the income statement which I mentioned in last episode, if you convert each line item on the balance sheet into a percentage of total assets, it will make it easier to compare financial statements across periods or with other companies, regardless of size. So that's step number one. That's really important. Another hack is to do horizontal and vertical analysis. Is to do horizontal and vertical analysis by performing horizontal analysis, by comparing line items across multiple periods to identify trends, or by doing vertical analysis, which involves comparing line items as a percentage of total assets with a single period to assess the financial structure of your company, is also really, really helpful.

Speaker 1: 16:07

Next, you could do ratio analysis. You can use financial ratios in conjunction with the balance sheet to gain deeper insights, such as interest coverage ratio, which is EBIT divided by interest expense, and asset turnover ratio, which is revenue divided by total assets, to provide valuable information on financial health and efficiency. Next, you can analyze the cash conversion cycle to understand how efficiently the company manages its working capital, which involves examining the inventory turnover, receivables turnover and payables turnover. But if you do this, it can provide super valuable insight into cash, which I love. And then also, you should be aware of off balance sheet items, which may include operating leases and contingent liabilities. These can significantly impact your company's financial health, but are not always readily visible on the balance sheet. So, in conclusion, that may have been a lot, but in conclusion, let me just wrap it up by saying this Reading a balance sheet like a CFO, it requires a strategic approach focusing on key metrics, analyzing trends and digging deeper into assets and liability categories.

Speaker 1: 17:20

By using benchmarking and advanced analysis techniques, like we talked about, you can uncover valuable insights that drive better decision-making and, ultimately, business growth. So, whether you're a seasoned executive, a business owner or an up-and-comer, these tips and hacks will help you to interpret balance sheets with the expertise and precision of a CFO. Now, like I said, if you want to take things to the next level, be sure to check out the program that I offer at byfiqcom. Or if you're listening to this and you're like Steve dang, that's a lot but super important and you feel like you don't have the time to dive into this, or maybe you have an accountant, but they're not strategic and you need help. That's what I do. You can reach out to me at cultivtavarocom and I can see if I can help you out. All right, thanks for tuning in. I hope you have a beautiful week. Be sure to share this and leave your comments below. I always love hearing from you. So if you wanna connect, shoot me an email at steve at byfiqcom, which stands for boostingyourfinancialiqcom, or hit me up on social.