Speaker 1: Hey guys, in today's video I'm going to show you how to read and analyze the balance sheet like a CFO does. So what we'll do is we'll jump into my computer here and I'm going to show you an example balance sheet for a company called Crab Cake Inc. And what we'll do is we'll go over the structure of the balance sheet as well as a couple of accounting definitions and then we'll go over the approach itself. How does a CFO approach the balance sheet? Which can be summed up as saying it's a risk-based approach. Meaning a CFO looks at each line item on the balance sheet and think of all of the risks associated with that line item and then think of ways to hedge against these risks. So we'll do all that and then toward the end of the video I'm going to show you a couple of financial metrics that you can apply that can quickly give you an idea of the financial health of the company based on the balance sheet. That's the topic of this video today so stick around. If you're new here, welcome, welcome. My name is Bill Hanna. I'm the financial controller. I'm a licensed CPA in the great state of New York and I have over 15 years of experience in the field of finance. Where I started out at PricewaterhouseCoopers as an auditor and then I transitioned out to private industry and then I worked my way up from a financial analyst position all the way up to a corporate controller position, which is what I do today. And this channel is all about giving you the summary or the juice of my experience over the last decade and a half. And I do this here in the YouTube channel as well as on my website through blog posts, an online course, and templates. So go ahead and check that out as well. All right, so diving into the balance sheet here. This is a balance sheet for a company called Crab Cake Inc and it's for the month ended December 31, 2019. And as we all know, the balance sheet shows the financial position of the company at a point in time. This is as opposed to the income statement which shows the financial performance of the company during a period of time. So here we're looking at a point in time which is December 31 or December 31, 2019. And the basic structure of the balance sheet is as follows. Total assets, which is $40 million in this case, will always equal total liabilities and equity. Which is saying that assets equals liabilities plus owners equity. Assets is what you owe equals what you own. So obviously assets is what you own in the company will always equal what you owe, which is total liabilities and equities. Obviously liabilities is something that you owe to third parties and equity is also something that the company owes, but it owes to the owners of the company. So it's very easy. What you own in the company or assets will always equal what you owe, which is liabilities and owners equity. All right, so let's go over assets real quick. So for assets, we'll always have current assets and then non-current assets or other assets. So basically current assets are those assets that can be converted into cash within 12 months. So when we look at current assets, it will include cash or cash equivalent. Here we have half a million dollars. We have accounts receivable, which is always the assumption is that you can always turn it into cash within 12 months because you'll collect your accounts receivable. And then inventory, which is $3 million in this case. And the idea is that all of these components, all of these three items on current assets can be converted into cash within 12 months. And that's why we call it current, right? So current means that it can be converted to cash within 12 months. And then we'll always have the other assets or non-current assets, which is in this case, property, plant and equipment, because the idea is that these are an investment in the future of the company. This is not something that the company intends to sell and turn into cash. And so this is other assets here. So the total assets for the company is $14 million. And then we can jump over to the liabilities section. So liabilities are also broken down in a similar fashion to assets, where we look at current liabilities and then we look at non-current liabilities. So current liabilities, similar concept. These are the liabilities or the obligations that are expected to be fulfilled, that the company has to fulfill within 12 months. And so an example here is accounts payable. The expectation is that the company will pay its accounts payable within 12 months, of course. And then you have accrued expenses. And these are all of the other expenses that the company hasn't yet booked as payable, but based on the accounting principle of the accrual principle, the company needs to accrue for any liability or obligation that it hasn't received an invoice for. So even though you haven't received an invoice for a service or a product from a vendor, you still need to accrue for it. And this is based on the accrual principle. This is one of the principles of accounting, the accrual principle. So accrued expenses, $300,000. And then we have deferred revenue, $500,000. Deferred revenue basically is, you can think of it as prepayments from customers. So as a company, you're receiving cash from your customers for a future product or service that you will deliver to them in the future. But the reason why we record it as a liability is because this becomes an obligation for the company, right? So you receive cash, you record the cash as a debit, but then your credit is deferred revenue, which is a current liability because this is still an obligation for the company to fulfill. And so $500,000 in this case is deferred revenue. And that will give us a total current liabilities of $8.3 million. And then we'll jump over to non-current liabilities. And these are the liabilities that we don't expect to pay for the next 12 months. So here we have a long-term loan or long-term debt of $3.5 million. And that gives us total liabilities of $11.8 million. And then after that, what's left over is going to be the stockholders or the shareholders equity of $2.2 million, which can be, you can think of it as subtracting total liabilities from assets. So if you take all of the liabilities and pay it off from the assets, what's going to be left over here is $2.2 million. And this is what the owners of the company can claim as their equity in the company, $2.2 million in this case. And then obviously, as we said, total liabilities and equities, $14 million is going to always equal total assets of 14 million. And this is one of the first things you look for when you're analyzing a balance sheet, right? Is total assets equal to total liabilities and equities? If they're not equal, then you're looking at a balance sheet that has an error in it, and you need to have that error looked at first before you can even begin to analyze the balance sheet. So the first thing is this number here, assets need to equal total liabilities and equities. And now that we've seen a quick overview of the balance sheet, let's talk about the approach of a CFO. How does a CFO approach the balance sheet? And we said at the beginning of the video that it's a risk-based approach, or what are the risks associated with each line item on the balance sheet? So let's dive right back in and look at the risk associated with each of the line items, beginning from the assets and going down all the way to liabilities. All right, so starting with current assets, the first item here is going to be cash and cash equivalents. So a CFO will look at this number and say, okay, I have half a million dollars in cash. I need to look at my current liabilities. So look at accounts payable here, and I'll see that my balance is $7.5 million, which basically is telling me that I need to pay off the vendors $7.5 million over the next, say, 60 to 90 days. So I'll look here and I'll say, okay, where is the money going to be coming from to cover all of these accounts payable? If I only have half a million dollars in cash, basically I'll look here at accounts receivable, and I see that I have a big balance. So $7 million in accounts receivable, this is expected to be collected normally in a course of business, say, between 45 to 60 days. So I'm expected to collect this number first so that I'm able to pay off my accounts payable. So this is the first thing that the CFO will look at, which is the obligations. So the CFO looks at the obligations of the company in relation to the cash position of the company to determine whether there's enough cash on hand to cover the obligations that are coming right up. And then the second thing that the CFO will look at is profitability. So we know that the accounts receivable, $7 million, is going to cover the obligations that the company needs to pay in the next, say, 90 days. But then what about profitability? Is this company profitable? Meaning, is this a cash machine? If my cash is running low here and it's half a million dollars, am I making enough profits to be able to generate more cash so that I'm hedging against the risk of running out of cash? So basically, when we look here at the income statement, looking for the company's income statement, and we see that net income is $120,000, which is adjusted for depreciation. When you put back depreciation, this is close to $200,000 for one month. So this is for the month of December 2019. So I can say, OK, on a monthly basis, I am profitable by about $200,000, which gives me a little bit more comfort that over the course of a year, let's say, I'm going to be generating somewhere around $2 million in profits, which will generate more cash to improve my cash position. So to summarize, for the cash-to-cash equivalent, the CFO will be looking at two things, obligations, and then also looking at profitability, which in turn will create cash flow. The next item here in current assets is going to be accounts receivable. So the CFO would look at two things when it comes to accounts receivable. They look at the balance, and they'll say, all right, it's $7 million. So I need to see an aging schedule of the $7 million. So the aging schedule is going to show you the breakdown of this $7 million in terms of what the customer owe by buckets. So the first bucket is going to be current accounts receivable, or the accounts receivable that the customer is not late on paying yet. And then it's going to show you then the breakdown from 30 days, 60 days, 90 days. So this way, you can get an idea of how much of this number is aged. And that can give you an idea on how much of this number can be expected to be bad debt. Basically, the customer is never going to pay this number. So the older the accounts receivable, the more likelihood that you're not going to collect it. So that's why it's important to look at that aging schedule of accounts receivable. And then the second thing that the CFO will look at is the day sales outstanding. So basically, day sales outstanding is a financial statement or a balance sheet metric that will show us how far or how long it takes. So here we have day sales outstanding, which is the number of days it takes to convert sales to cash, which basically takes the accounts receivable balance divided by credit sales and then multiplied by the number of days in the period. And to apply this to our example here, if we take the accounts receivable balance, which is $7 million divided by credit sales, $4 million, which we can see here in a balance sheet or the income statement rather, if we switch over to the income statement, we have sales of $4 million. So we take that number and we plug it here. So we have $7 million AR divided by credit sales, $4 million times 31 days. This happens to be a month with 31 days. Then that gives us a result of 54 days. So 54 days. So this is saying that the company takes on average 54 days to convert its sales into cash. So this number is a little bit on the higher end. You want this number to always be somewhere around 30 to 45 days. You know, if it goes up to 60 days, then it's a little bit above average. Above 60 days, then there'll be a bad signal. So these are the two things that the CFO would look at for accounts receivable. First is the aging schedule, and then they will look at day sales outstanding or DSO. The next item in our list is inventory. And basically when a CFO looks at inventory, they're looking at a balance of $3 million in this case, and you want to make sure that none of it is nearing expiration or obsolescence. So if you have $3 million worth of inventory, it doesn't mean that all of it is sellable, right? Maybe some of it you're not going to be able to sell. So if you have inventory, especially if it's like a food inventory and a big chunk of it is food products that are nearing expiration or are going to expire very soon, so this is a risk here. So if you're looking at an aging schedule of inventory, you can tell by bucket how much of this inventory needs to be moved quickly in order not to be written off or not to lose money on it. So a CFO would want to look at a breakdown of what makes $3 million in this case to determine how much risk is associated with this inventory, how much of it needs to be moved quickly. So now we've covered all of the items in current assets. So the next item here is non-current assets or other assets. And we have here property, plant, and equipment. And when a CFO is looking at this balance of $3.5 million, they're asking themselves a question of, is this entire balance appropriate to be booked in a balance sheet? Meaning is any of this obsolete? Like if this is machinery or equipment, are we using all of it or some of it is obsolete and needs to be written off? So this is the risk here when you look at this number, is to know the composition. Look at a breakdown of the assets that are included here and determine whether all of them are in use, all of them have a future economical life for the company, so this balance is appropriate. Otherwise if it's not, if a part of it needs to be written off, then that's a hit to the P&L and that will reduce this number here in the balance sheet. All right, so now that we've covered assets, let's look at liabilities. And the first item in current liabilities is going to be accounts payable. And when a CFO looks at this number here, the balance $7.5 million, they think of two things in terms of risk when it comes to accounts payable. So the first thing they think of DPO, or days payable outstanding, which is basically the amount of time that the company takes on average to pay its obligations to vendors. So each company has a unique cycle of payment. Sometimes it's a quick cycle of 30 days, sometimes it's maybe 90 days or 120 days when it's like a bigger supply chain when you have vendors for your materials. So basically, the longer the better in this case. And the CFO will be looking to measure the DPO, and the DPO, days payable outstanding, the formula for it is purchases on credit divided by the accounts payable balance, and think that to multiply it by the number of days in the period, and that would give you the DPO. And typically, you want that number to be as long as possible so that you want to shrink your cycle of receiving from your customers and make the cycle as long as possible so you have an advantage. And this is like a cash flow advantage when you collect quickly and then pay off on the longer duration of time. So DPO is the first thing to look at. And then the second thing is going to be aging. So similar to when we talked about accounts receivable, also when we look at accounts payable, we want to look at the aging of the composition of this $7.5 million to determine how much of it is current and how much of it is aged. Because the risk here is that if a lot of this balance is aged, meaning that we owe this for the past, let's say, maybe six months or so, this is a sign of trouble. So if the company has a lot of accounts payable that is aged or that is past due, it means that the company isn't able to collect and time from its customers and pay off its vendors. So that's why it's really important to look at aging. That will give you a quick idea. Obviously, when you look at the aging schedule, you want as much as possible of that $7.5 million to be sitting in the current section of the aging schedule and not being past due. So this is what the CFO will look at when it comes to accounts payable. The next item is going to be accrued expenses. And we have $300,000. And we said before, the accrued expenses is what the company is accruing for in terms of liabilities that the company haven't received an invoice from a vendor yet. So what the CFO would look at here is he would ask for a schedule of this number here just to determine whether the company is appropriately accruing for everything that it owes. So only when you see a breakdown of the number, that's when you can make that determination. So a schedule here would give you an idea. And then the next item is going to be deferred revenue. So a CFO would look at this number and think, OK, this $500,000 is received in advance from customers for future services or products. I need to know whether the company is going to be able to make good on this obligation. So the CFO would want to look at and see what the customer is paying for. Let's say it's paying for a product. And then we'll ask a question, OK, is this a product that we have on hand? Is this something that we need to manufacture from scratch? Are we going to be able to make good on this obligation here? And so you need to know what's included in this number here. And again, this is usually going to be a schedule that you can obtain. The company should keep a schedule of all of the prepayments that it receives from customers. So this covers pretty much the section current liabilities. Now we come to non-current liabilities. And the CFO would look here and see that the company has a long-term debt of $3.5 million. And so the first question is to ask for a breakdown of this number just to see the maturity. So you want to see the breakdown by maturity date of when do we expect to pay off this number? Is this made up of loans that are like three-year or five-year or 10-year loan? So basically, then you can plan in the future how you're going to pay off this loan. It's similar to when you own a house or a property and you want to know how long is the mortgage, right? Is it a 10-year, 20-year, 30-year mortgage? It's the same thing here. If you have a long-term debt, first thing you want to know is how long will it take to pay off or what is the maturity date of this loan? So you come to total liabilities and it's $11.8 million. And there are a couple of financial metrics or KPIs that you want to be using here to make sure that the company financial health is not something that is in jeopardy. So the first thing you want to compare is total liabilities. You want to compare that to equity. And this is a financial metric here that is called a debt to equity ratio, which is the relative proportion of shareholders' equity in debt used in financing the company's assets. So the formula for it is liabilities divided by equity. And if we apply this here, liabilities is $11.8 million divided by equity, which is $2.2 million. And it will give us a result here that is 5.4. So this number 5.4 is saying that the company is using 5.4 times more debt than stock to finance its business. This could be a sign of too much leverage, but it might be also the company taking advantage of low interest rates. So there are two sources of financing for the company. It's either raising debt, in this case, which is the long-term debt, or selling stock, which is equity. And so each one of them has a cost to the company, and it's up to the company to determine which one is cheaper. If the interest rates are low in an environment where the feds are lowering the interest rate, then it makes sense for the company to raise more money from debt over financing. And so in this case here, you look at this metric and you can determine the debt to equity ratio. The other financial metric to look at here is the servicing of the loan itself, which is the interest coverage ratio. So this is measuring how many times can a company cover the interest payment from earnings in a given period. And so basically you take the earnings, or EBIT in this case, earning before interest and tax, divided by the interest expense. And so in this case, it's $250,000, which we can get here from the income statement. When you take the EBIT, which is earnings before interest and tax, $250,000 divided by $80,000, which is the interest expense. Again, that's from the income statement here as well, $80,000 of interest expense. And the result is 3.1. And so this is saying that the company can cover its interest payment three times, or 3.1 times, over its earnings. And so this is good. So the company has makes enough in earnings to cover its interest by a factor of three. So this is a good sign that the company is, in fact, is able to service its interest on the actual loan. There are a few other important ratios, such as the liquidity ratios, quick and current ratios, that are used by CFOs to analyze the balance sheet. And also there are financial leverage ratios, such as the debt to capital ratio and debt to asset ratio, as well as the financial leverage ratio. And these are all important ratios that the CFOs use to analyze a company. I'm going to leave a link to this file down below in the description in Excel, so you can download it and look at the balance sheet, the income statement, and the actual ratios that are used here. So you can find the link in the description down below. So the link in the description below will lead you to a product on my website to purchase, which is really inexpensive. And it includes the Excel file that we discussed today with its balance sheet, income statement, and financial metrics, formula, and interpretation, and also an actual PDF summary, a one-page summary of the metrics that we looked at today, so you can keep it as a handy reference for the future. The reason why this is a paid product versus a free giveaway, which sometimes I give on this channel, is because this template took a lot of time for me to put together and test and make sure that it's correct and accurate. And also because when you buy a product through this channel, you're also supporting the channel and making sure that I'm able to give you the content or the free content that I put out every week. That's it for this video. If you liked it and you learned something new from it, give it a big, fat thumbs up and share this video with someone that you think might benefit from it. And I'll see you in the next one.