Balance sheet analysis is commonly conducted quarterly and annually to help lenders and other creditors, investors and financial intermediaries determine the company’s creditworthiness, earning power and profitability. It typically encompasses solvency analysis and liquidity analysis.
Balance sheet analysis generally begins with the comparison of total assets and liabilities. When a firm’s total assets are greater than its total liabilities, it is balance sheet solvent and its net worth is positive. When it total liabilities exceed the total assets, it is balance sheet insolvent and its net worth is negative. The balance sheet solvency of a firm is measured using leverage or capitalization ratios.
The ability of a company to service its debt out of cash flows from its current operations is liquidity. Liquidity analysis is the assessment of a firm’s ability to service its debts through the use of the cash resources available to the firm as of the balance sheet date and the cash to be generated through the firm’s operating cycle.
|Change in Liquidity|
|Ordinary cash flow|
|+/− Change in working capital|
|+/− Change from investing activities|
|+/− Change from 3rd party financing activities|
|+/− Change from owners financing activities|
|= Change in liquid assets|
When assessing a firm’s liquidity, creditors must consider the quality of the current assets and the nature of the current liabilities. The degree of liquidity of a firm is measured using liquidity ratios.