Question

What is meant by a firm having a strong balance sheet and income statement? What analytical tools are used to make this judgment?

Answer 1

Solution:-

When it is said that a firm has a strong income statement, it's generally referred to the following features:

• Strong and consistent revenue and earnings growth for the business which is the primary consideration for investors in a desirable business
• Strong gross profit margins that offer enough cushion for the company to cover its indirect costs, and provide enough net income to investors relative to the risk they have taken in their investments
• Low degree of operating leverage which shows that contribution margins are substantial to cover the fixed costs
• Low degree of financial leverage which shows that operating income of the business is substantial to cover the interest expenses
• High net profit margins which is a reflection of a healthy business that has the stomach to go through tough times
• High returns on capital, return on equities for investors

When it is said that a firm has a strong balance sheet, it's generally referred to the following features:

• Comfortable debt to equity ratio considering the nature of the business.
• High level of cash reserves which are enough considering the requirement of business, opportunities for acquisitions, etc
• High current ratio that shows business' ability to cover its current liabilities through current assets, i.e. strong working capital management of the business
• Growing fixed assets over the period, which shows strong capex and reinvestment in company's growth
• High retained earnings is a must in a growing business because they show that the business retains its earnings for reinvestment in growth rather than distributing to shareholders. A management that sees potential for business growth prefers to retain the major part of earnings rather than giving them away

Analytical tools used to make this judgement:

The various tools used to analyse the strength of balance sheet and income statement are as follows:

• Growth analysis of key metrics such as revenue, profits, debt, capex, working capital investments over a period of time (e.g.: 5 years) which tells about the growth and stability of business. A negative trend is bad for the health of balance sheet and income statement, and vice-versa. For this purpose, the analysts can use various charts such as bar charts, line charts, etc
• Profitability ratios including margin ratios, return ratios, etc
• Liquidity ratios which displays a business' liquidity strength to the investors
• Activity ratios which shows a business' efficiency in its operations including debtors turnover ratio, invesntory turnover ratio, fixed assets turnover ratio, etc.
• Leverage ratios which shows the appropriateness of the company's capital structure