Sunday, April 19, 2009

Balance Sheet Analysis and Stock Selection

Among financial statements of a company, balance sheet is the one that attracts the attention of most large investors. But for some reason, retail investors and even some of the analysts ignore financial statements including the balance sheet and give much importance to earnings. True those earnings is an important criteria to look at but balance sheet is the one which can tell us about the company’s ability to fund for its future growth along with the debt and inventory details. Reading the balance sheet is crucial to understand whether or not the company we are investing in is capable of generating real value to the shareholders. Let us discuss in detail about the balance sheet and its importance in stock selection.
What is Balance Sheet?

A concise report or statement that gives us details regarding the company’s assets, liabilities and net worth is what we call it as balance sheet. Understanding the balance sheet will give us clear picture regarding the liquid assets of a company which can be cashed in no time in case of emergency funding or fall out.
Sample Balance Sheet Structure


Components of Balance Sheet

1. Assets Section which includes two sub sections namely current assets and long term assets.


2. Liabilities which again includes two sub sections namely current liabilities and long term

liabilities.

3. Capital or Equity section

It is called as balance sheet because asset section has to be balanced by the sum of liabilities and capital section.

Total Assets = Total Liabilities + Shareholder’s Equity or Net Worth

Now let’s see one by one.

Assets

Assets of the company include the following.


1. Cash and Cash Equivalents like Bonds, Certificate of Deposits, and Fixed Deposits etc.
2. Accounts Receivable
3. Inventory
4. Non-financial assets like buildings, infrastructure, equipments, patents and goodwill.

While cash and cash equivalents, accounts receivable and inventory are considered to be current assets, non-financial assets are usually termed as long term assets.

Current Assets

Assets that can be converted in to cash in less than 6 months fall under this category. Current assets are the ones that a company relies on to fund its day to day operations and immediate cash needs. As we know cash and cash equivalents are ready made cash components of a company. Accounts receivables are the ones which a company expects from its clients in the short term. Inventory includes products or services of a company that’s readily available to be sold. All of these are considered as current assets due to the fact that these are readily available or can be converted as cash within 6 months time period.

Long Term Assets

Assets like Buildings, Infrastructure, Equipments, Patents and goodwill are considered as long term assets as converting them into cash takes more than one year time period. Among these, Buildings, Infrastructure and Equipments are considered as tangible assets (Physical in nature) while patents and goodwill are considered as intangible assets (Not in physical form).

Total Assets = Current Assets + Long Term Assets

Liabilities

Anything that a company owe to others is considered as liabilities and can be further divided into current liabilities and long term liabilities based on the time period of the loan.

Current Liabilities

Debt that has to be paid within 6 months or 1 year time period is termed as current liabilities. Accounts payable and current borrowing / short term loans are the ones we see usually in the balance sheets under current liabilities. One company’s account payable amount goes to another company’s account receivable amount. Income tax of a company might also come under this category. In essence anything that has to be paid within a year comes under current liabilities.

Long Term Liabilities

Debt that can be paid beyond 1 year time period is termed as long term debt. Long term loans usually come in this category.

Total Liabilities = Current Liabilities + Long Term Liabilities


Equity / Capital

Capital or Equity is the amount that a company invested in the business. Companies usually report the par value of stocks in the balance sheets as equity capital and not the market value. For example if State Bank of India has total of 1000 shares and the par value is Rs. 10 then they report only Rs. 10000 and not the Current market value of the stocks. We also see retained earnings in this section which is company’s earnings minus any payout to shareholders (Dividend and Buy back). Some companies report capital in excess of stock which is an additional amount that a company gets in issuing stock in excess of the par value.

If we add equity with total liabilities, the sum should match the total asset value.

We have discussed enough regarding the balance sheet components and it’s time to look at things which we really need.

Important things to consider from Balance Sheet

We can calculate lot of different ratios and numbers from the balance sheet but I would like to present only 4 important things which we really need.

Current Ratio


If we divide the Current Assets by Current Liabilities, we get this Current Ratio which is really useful to understand how well the company is capitalized in the short term. Usually if a company has the current ratio of 1.5 – 2 or more, that’s sufficient to meet the short term obligations. But comparing this ratio among the peer group might shed more light. Because if a company has the ratio of 10 then that means, the company is sitting on huge cash and is not properly utilizing it while the company with a ratio of 0.5 is sitting on short term debt and can be vulnerable at any time. Hence, comparing the ratio with peer group helps to select the best positioned company in terms of present and future.

Debt / Equity Ratio


We can get the Debt / Equity ratio if we divide the Total Liabilities by Shareholder Equity. Lesser the number better the stock. Suppose if Airtel has the DE Ratio of 0.3, then that means Airtel is not burdened by debt concerns. If DE Ratio is less than 1, then it is widely considered a good number. Sometimes, we might need some information from income statement as well to calculate this DE Ratio.

Quick Ratio


Quick Ratio = (Current Assets – Inventories) divided by Current Liabilities. Quick Ratio is calculated to understand whether the company is depending on its inventory for immediate cash needs. This is more applicable to FMCG and Retailing companies. Quick Ratio in excess of 1 is usually enough for a company to pay for its immediate cash needs.

Working Capital

Working capital can be arrived at by subtracting Current Liabilities from Current Assets and it can be either positive or negative. Higher the number, it is better for the company. Working capital is the single important source for a company to fund for its day to day operations and for future growth. If a company has ample working capital then that should be in a good shape. Some people divide the working capital by market capitalization to see the company’s hidden value. Suppose Pantaloon has working capital of about 10 Crores and its Market cap is 20 Crores, then Working Capital Ratio is 0.5 or 50 % (10/20). This ratio simply tells that 50 percent of Pantaloon’s market cap is backed up by its working capital which is a dream number. We can think in another way as well. If pantaloon has to go out of the business for some reason, then shareholders stand to receive 50 paisa for every one rupee from the working capital alone.

These are the important things one should consider in analysing a balance sheet. But depending on the knowledge and skills, one can calculate few other ratios and numbers.

Where do we get the Balance Sheet of a Company?

We can get it from the company website under the “Investor Relations” section. Alternatively we can get it from brokerage sites.

Kumaran Seenivasan.
http://www.stockanalysisonline.com/

8 comments:

Amar April 20, 2009 at 2:33 AM  

Hi Sir,

Very useful and easily explained way to understand balance sheet. i think it's useful for all the readers.

thanks for your hard work.

Regards
Amar

Chirag Ali,  April 21, 2009 at 9:43 AM  

Hello Mr Kumaran

I Thought Reading Balance Sheet is like Knowing Rocket Science. I Thank you for explaining in Simple and understandable way

Thanks Indeed

Chirag Ali

Vpoorni,  April 21, 2009 at 9:49 AM  

Hi Sir,

Your post always explains things very simply and it is easy to follow. Keep up the good work. Best wishes!

Poornima

Kumaran April 23, 2009 at 7:51 PM  

Thank You all for your comments.

Sunil N. Karande April 24, 2009 at 4:24 AM  

Sir thanks for explaining in simple sentences.....thanks a lot....

karuppiah December 17, 2009 at 11:32 AM  

I have few doubts.
1)In the Balance sheet we have the term 'Reserves'. What does it include.
2)I understand the equity capital is calculated based on face value. But now the IPOs have higher price than the face value. So how the equity capital will be calculated?
3) Generally in the asset the value given will be original value minus depriciation value. How the depreciation value is balanced?

Please clarify these doubts.

sarah,  November 15, 2010 at 1:42 PM  

It was difficult for me.. Thanks for advices to prepare good balance sheet format..

Inventory Management Software December 30, 2010 at 4:45 AM  

I really appreciate your post and it was superb .Thanks for sharing.I would like to hear more about this in future.
Regards:
http://www.blackitsoft.com/inventory-pos-software.aspx

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