How to Do a Balance Sheet Analysis

A balance sheet is a financial statement that details a company's financial positions as of a given date, typically the end of a fiscal quarter or year. The balance sheet is formatted so it presents a company's asset base balanced against its liabilities and shareholders' equity. Total assets minus total liabilities equals the company's net assets, or shareholders' equity. Balance sheets can be unclassified or classified. Unclassified balance sheets are crudely prepared and typically used only for internal reporting; the classified version categorizes assets and liabilities as short term or long term and lists them in ascending order of liquidity.

One important step in the analysis is to common size the balance sheet, which involves presenting each asset line item as a percent of total assets and each liability and shareholders' equity line item as a percent of total liabilities and shareholders' equity. This allows for making simple comparisons at a highly detailed level. For example, you may want to analyze cash as a percent of total assets if the subject company's solvency is a concern. Likewise, you may want to observe trends in accounts receivable as a percent of total liabilities and equity, if collections is an item of importance.

A benchmark analysis is critical to analyzing the balance sheet. It requires obtaining benchmark balance sheet data -- in ratio form and common sized -- from a peer group for comparison. It is important that the peer group is highly comparable in terms of line of business, size and other quantitative and qualitative factors so the comparison is meaningful. The Risk Management Association published its "Annual Statement Studies," which provides a large amount of detailed financial data, broken down by industry. It is useful for this type of analysis.

The ratio analysis is also a critical component of analyzing the balance sheet and ties in to the benchmark analysis. A ratio analysis requires using the balance items to calculate various financial ratios, which can be compared to financial ratios obtained from the benchmark peer group. For example, a liquidity ratio like the current ratio -- equal to current assets divided by current liabilities -- can be compared against the peer group median. Working capital is another important measure. By calculating ratios using historical results, you can observe any upward or downward trends in the data. If no trend exists, erratic performance may imply a certain level of operational risk associated with the company.

Shareholders' equity is a key indicator of company health and shareholder wealth. Observe whether shareholders' equity trends upward or downward or is erratic. You can also calculate return on equity from the shareholders' equity section of the balance sheet. Return on equity is equal to net earnings divided by shareholders' equity. Net earnings is an income statement item, but for each fiscal year, the change in retained earnings plus dividends paid equals net earnings. Both retained earnings and dividends paid are available via the shareholders' equity section of the balance sheet.