The Numbers Game: Fundamental Analysis By Reading A Balance Sheet
Numbers never lie—how can you make smart investing decisions based on a company’s balance sheet?
*This is in partnership with BQ Prime BrandStudio
Before investing in a stock, it is important to play the numbers game. This entails taking a thorough look at the company to learn most (if not everything) about it. When it comes to getting the inside story of a business, fundamental analysis is a must.
Fundamental analysis involves a study of internal factors (underlying business fundamentals) and external factors (economy) and the impact they have on a stock. It is the preferred method of investors to discern whether a stock is fundamentally strong or weak.
Why is balance sheet important?
A balance sheet is where it all begins. It reflects the company’s assets, liabilities, and equity at a given point in time. Based on the formula, assets = liabilities + equity, the balance sheet shows how well a business has balanced assets with liabilities and shareholder equity. Better financial management is likely to result in more profitability and cash flows.
Reading a balance sheet is thus critical for investors looking to leverage and harness data for making smart, informed investment decisions.
Reading a balance sheet
The three categories in a balance sheet that warrant close attention are assets, liabilities, and equity, all of which offer several clues about the business.
Current assets: These assets are expected to be converted into cash in an operating year. Cash and equivalents are the most liquid current assets, while inventories, trade receivables, and investments also fall in this class.
Although companies having high cash and equivalents are desirable, an excess may indicate failure to invest in the business for future growth. High trade receivables may signify more credit sales and less cash sales, which may come with recovery risks. Inventory levels and turnover should be studied since a higher inventory may indicate reduced operating efficiency.
Non-current assets: These are fixed assets and not to be liquidated within the operating year. Examples are property, plant, and equipment (or PPE), work-in-progress capital and tax assets, along with financial investments like equity holdings or loans advanced.
How efficient fixed assets are in generating revenue is calculated by fixed asset turnover ratio (total revenues/fixed assets). Financial investments should also align with the business model of a company.
Current liabilities: The financial payables for the operating year are called current liabilities. These comprise short-term loans, tax liabilities, and trade payables.
A higher payables turnover (total sales/payables) is a sign of efficiency as it reduces the working capital required. However, concerns may mount if the turnover goes beyond a company’s repayment capacity.
Non-current liabilities: This is long-term debt and includes long-term loans, trade payables, or deferred tax liabilities.
The debt/assets ratio of a company should align with industry standards. High financial leverage from debt financing increases interest payments and may lead to volatility in earnings, while steady earnings and high return on assets are indications that debt can be safely absorbed.
Shareholder equity is the company’s net worth built to date. The total equity component can be further divided into:
Paid-up capital: It is the capital raised by the company from its shareholders by issuing shares of stock.
Reserves and surplus: These are generated from accumulated profits. An accounting profit will see an increase in reserves, while an accounting loss will cause a dip. A portion from accumulated profits may be given to shareholders as dividends.
By comparing a stock’s market price with its book value per share, which is calculated by dividing the book value (total equity) with total outstanding shares, and looking at the price-to-book ratio, one can identify whether the stock has intrinsic value.
Ratios used for analysing balance sheets
· Debt-to-equity ratio: Calculated by dividing the total debt with shareholder equity, the ratio shows how leveraged a business is and how much is debt capital. A higher debt-to-equity ratio indicates a lower cost of capital but a potential risk due to high debt financing.
· Return on equity: A measure of profitability, RoE is calculated by (net profit/equity share capital) x 100. A high RoE is desirable.
· Current ratio: A measure of total liquidity, it is calculated by dividing current assets by current liabilities. A higher current ratio indicates that a company is capable of paying debts, but may also signify inefficient use of assets.
Numbers don’t lie. So, if you’re basing your investment decision on the numbers game and do a thorough review of a company’s balance sheet, the odds of your investment paying off definitely improve.