The balance sheet analysis and the below ratios inform us about the company's financial balance.
  • Will your customer be able to pay you on the due dates of your invoices?
  • Is he solvent?
  • Does he have sufficient liquidity to honor its short-term and medium- and long-term debts?
This analysis will enable you to determine it.

Solvency Ratios

 Total liabilities /Total equity: It’s showing the proportion between equities (internal financing) and debts (external financing). The more important the internal financing is, the lower the risk of bankruptcy.
Who really owns the company?
Shareholders Equity / (equity + liabilities) = %
Bank Bank loans / (equity + liabilities) = %
Creditors (including suppliers) short term liabilities / (equity + liabilities) = %
The total makes 100%. The higher the percentage, the lower the risk.
 Loan ratio: Loans payable > 1 year / equities. Shows the banking debt level. The lower it is, the less the company is financially dependent on its banks.
 Should not exceed "1" in which case the banking dependence level is too high.
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Liquidity ratios (ability to honor short-term debt)

 Cash ratio: Accounts receivable + cash and cash equivalents - short-term debts. This ratio is an excellent indicator about the capacity to refund the short term debts (thus to pay its suppliers).
  >1 solvency is good. <1 The company must sell its inventories to ensure the payment of its creditors. Tensions in the treasury and delays in payment can appear.
 Daily Sales Outstanding (DSO): Accounts receivable / Gross revenues x 360. This indicator shows if the accounts receivable are well or badly managed and if the company is able to be paid by its customers.
60 days if the accounts receivable are well managed (LME law in France restricts payment terms up to 60 days maximum). Above 90 days is worrying, especially if its customers are French (payment terms can be longer with foreign customers).
 Daily Payable Outstanding (DPO): Accounts payable / cost of goods x 360. DPO shows payment behavior with suppliers. Be careful with companies with a high DPO; you may be paid with a delay.
This indicator should remain below 90 days.
 Inventory turnover days: average inventory / cost of goods sold x 360 days. A ratio showing the days it takes to sell the inventory on hand.
The lower the result (< 20 days), the better company controls its purchasing processes and its WCR. If it is high (> 30 days), the WCR is increasing, which may generate tensions in the Treasury. High inventory levels are unhealthy because they represent an investment with a rate of return of zero.

The financial statement falsifications

Some companies balk at publishing financial statements representative of their real situation and falsify their balance sheet to post a situation in conformity with their wishes. By this way, they try to:
  • hide financial problems that could worry their partners (customers, bankers, suppliers, shareholders, etc.).
  • diminish the net income in order to pay less taxes or to not reveal their business margin.
 In order to perform a relevant solvency analysis, it is needed to detect these falsifications which can skew the assessment and the analysis that results from it.

A real example of balance sheet falsification

  Accounts receivable falsification: here is an assessment that shows a seemingly correct financial situation.
P & L K€ Assets K€ Equity & Liabilities K€
Gross revenues 12 625 Fixed assets 413 Equity 895
EBIT 516 Current assets* 5652 Liabilities 5170
Net income 265 *including accounts receivable 4983    

 If we look in detail at the balance sheet, we can see that the DSO is 144 days, which is very high.
Why ?
because this company underwent two unpaid periods for a total amount of 2 million euros without reflecting it in their balance sheet and income statement, which are in fact completely wrong.  Normally, the unpaid invoice should have been written off, which impacts the EBIT and the Net income, which become largely negative. The loss in the form of a reduction from equities to -1.1 million euros. The "fair" financial statements are completely modified, as below:

P & L K€ Assets K€ Equity and liabilities K€
Gross revenues 12 625 Fixed assets 413 Equity -1105
EBIT -1484 Current assets* 3652 Liabilities 5170
Net income -1735 *including accounts receivable 2983    
Current assets are largely lower than the short-term debt. The company is unable to refund its debts and goes bankrupt (which happened a few months after the publication of the false financial statements).
Be attentive to the figures leaving the standards. A daily sales outstanding of 144 is sufficiently high to cast doubt on the accuracy of the accounts and ask for explanations from your customer.
A similar falsification is very common in the valuation of inventories : when a company overestimates inventories values, its net income is higher than it should be, as it should be impacted by the devaluation of obsolete inventories.
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