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Interpreting the Balance Sheet

How to use financial statements as a management tool, Part 1

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The following is the first in a series of three articles on using financial statements as a management tool. The series references the 2006 annual report from Target Corp. from the retailer's web site. The financial statements begin on document p. 24 (p. 43 of the PDF file).

The information provided here allows you to calculate several financial ratios that measure company performance. Additionally, current balance sheets should always present data from at least one previous period, so you can compare how financial performance has changed.

Identify a public company in the same industry as your startup and download their financial statements from their Web site. Using Target Corp. as an example, we’ll analyze the data in their balance sheet. Here are a few key ratios to calculate. Note that all figures represent millions of dollars.

Quick ratio: This measures Target’s ability to meet its obligations without selling off inventory; the higher the result, the better. It is expressed as current assets minus inventories, divided by current liabilities. In Target’s case, that is 14,706 minus 6,254, divided by 11,117, which equals 0.76.

Interpretation: If this number declines over time or falls short of your benchmark, you may be investing too much capital in inventory or you may have taken on too much short-term debt.

Current ratio: This is another test of short-term liquidity, determined by dividing current assets by current liabilities. In Target’s case, that is equivalent to 14,706 divided by 11,117, which equals 1.32.

Interpretation: This number should be above 1, and it’s usually a sign of strength if it exceeds 2. If this number is below 1, that means your short-term liabilities exceed your short-term assets. A liability is considered current if it is due within a year. An asset is current if it can be converted into cash within a year.

Debt-to-equity ratio: In brief, divide total debt by total equity. In Target’s case, the denominator is termed a shareholder’s investment because Target is a public company. Using Target’s data, that ratio is expressed as 8,675 divided by 15,633, which equals 0.555.

Interpretation: Long-term creditors will view this number as a measure of how aggressive your firm is. If your business is already levered up with debt, they may be reluctant to offer additional financing.

Working capital: This refers to the cash available for daily operations. It is derived by subtracting current liabilities from current assets, which in this example is 14,706 minus 11,117, which equals 3,589.

Interpretation: If this number is negative, that means your firm is unable to meet its current obligations. To improve this number, examine your inventory management practices; a backup of goods and the resulting loss in sales can take a toll on your business’s cash resources.

Part 2: The Income Statement

Part 3: The Cash Flow Statement

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