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Stock Investing | Fundamental Analysis: How to read a balance sheet

Fundamental analysis is the basic premise of gauging the health of a company’s financial position, business model, sustainability, as well as profitability. Therefore, it is important for investors to know the structure of financial statements, and to be able to read them and get meaningful insights about their company.

What is a Balance Sheet?

A balance sheet, also known as “Statement of Financial Position,” provides a snapshot of the company’s position in terms of assets, liabilities (including debt), and shareholders’ equity (including reserves of accumulated profits) at any given point in time. Therefore, it is defined at a point in time instead of “over a period” unlike the income or cash flow statement, which summarises the financial performance over a period (e.g., a quarter or a year).

The Balance Sheet Equation

The balance sheet presents assets, liabilities, and shareholders’ equity in the form of a governing equation:

Total Assets = Liabilities + Shareholders’ Equity

Intuitively, it suggests that any company’s assets are funded by the funds provided by its owners (or shareholders), and the money borrowed from banks or other operational sources (suppliers). Assets are presented in a separate list, and liabilities and shareholders’ equity are clubbed together to represent the balancing equation.

Assets

Current Assets: These represent the assets that are relatively liquid and/or expected to be converted into cash within one year. The most liquid of these are “Cash and Cash Equivalents,” which are the cash at hand or in the bank and other equally liquid securities.  “Receivables” are the money that your customers owe you for the goods that you have delivered. “Inventories” represent the monetary value of the products being made or are finished but are yet to be sold. Both receivables and inventory can be long-term assets based on their expected time of liquidation (to be converted in cash), but they usually fall under the current asset category.

Analysis: Heavy Cash & Equivalents at hand are considered good. But if it is more than a certain limit, it indicates the company’s inability to put the cash to good use (high yielding projects), and hence an opportunity loss. High/increasing receivables suggest lower cash sales (and high sales on credit), indicating poor bargaining power and an increased risk of recovery. Higher/increasing inventory levels suggest the company has a poor operating efficiency (slow conversion of raw materials to finished goods and into cash by selling them). However, levels of inventory are seen with respect to “Cost of Goods Sold” (inventory turnover ratio) and not in absolute terms, as an expanding business will naturally require higher absolute levels of inventory. Similarly, receivables are seen with respect to total sales (receivable turnover ratio). The comparison is valid only if done with companies with a similar business model.

Non-Current Assets: These are the assets that are not meant to be liquidated in the near-term (within one year). Fixed Assets or “Property, Plant, and Equipment” or “PPE” include the value of the buildings, offices, machinery, and other equipment of long-term use. Every year, the value of the PPE will decrease by the amount of “Depreciation Expense,” an item from the income statement, which intuitively represents the decrease in value of assets due to regular wear & tear or aging of the assets. Therefore, the value of PPE is adjusted for accumulated depreciation from their original value (when they were bought or created) before presenting. “Long-term Investments” may include financial investments (equity stake in a company, mutual funds, or other securities for long-term purposes) or advances (loans) extended to other parties (customers, group companies, etc.)

 Analysis: Fixed Asset Turnover ratio (Total Revenues/ Fixed Assets) represents the efficiency of PPE to deliver revenue. Increasing financial investments may be a red flag if the company’s core business model is unrelated to financial investments.

Liabilities

Current Liabilities: They include “payables” or payments pending to suppliers. Short-term loans from banks (tenure less than one year) form part of “Short-term Borrowings.” Higher Payables turnover (Total Sales/Payables) reduces the invested capital in operations (working capital), and it indicates efficiency, but a sharp increase beyond the capability of the company to repay on time is a point of concern.

Long-Term Liabilities: They are majorly constituted by long-term debt. The Debt/Assets ratio should be comparable to industry peers. High leverage increases interest costs and makes earnings volatile. Companies with stable earnings profiles and high Return on Assets can absorb more debt than others.

Shareholders’ Equity

Paid-up Capital: In simple terms, this is the capital provided by the owners (shareholders) to the company.

Reserves and Surplus: This is the company’s reserve of accumulated profits. It increases when the company posts an accounting profit and decreases on accounting loss during a period. The company may choose to distribute some of the accumulated profits to shareholders in the form of dividends, which will reduce the reserves and surplus account.

Analysis: Total Equity (Reserves and Surplus + Paid Up capital) is essentially the book value of the company. Dividing this by the total outstanding shares gives Book Value per Share (BVPS). Comparing the market price of a stock to its book value is a common way of fundamental analysis. A lower Price-to-book ratio (than industry average) for a company with a good return on asset and growth prospects (vis-a-vis industry average) means the stock is undervalued.

Debt to Equity ratio measures the credit health and the risk posed by financial leverage. However, all these ratios must be compared across companies from the same industry groups and with similar business models.

Related :  When To Buy Growth Stocks: How Pyramiding Up Can Be As Easy As A Cup Of Coffee

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Read our last week’s article: Selling rules: How to make most out of your trade

 

Disclaimer: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. It is for educational purposes only.

 
 
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