How to understand company’s financial position – Part 1 (Balance Sheet)

If you want to be investing in individual companies, it is important that you have at least a basic understanding of the company’s finances. Some people think that you don’t need to look at these things at all, or are simply not interested, but this is probably a wrong attitude. If you are buying shares, think of it as buying part of a business (because, you are!). Now imagine, that you were actually buying 50% of your favourite corner shop… Would you be interested in how much is it making? How much it costs to run the business? How much is the rent? Is there any debt?… This is the attitude you should develop when thinking about the financials of a company that you want to invest in.

What are the most financial figures?

When investing in the business, you should be mainly concerned about three things (when it comes to financials)- how much does the company have, how much it makes and how much it owes.

How much does the company have? aka. Balance Sheet:

Balance sheet is a type of financial statement, where you can see the breakdown of all what the company has and owes. It is called balance sheet, because it has to balance- assets (what the company has) and liabilities (what the company owes) + owners’ equity. So the equation is:

ASSETS = LIABILITIES + OWNERS’ EQUITY

When you think about it, it makes perfect sense- owners’ equity (what is left for shareholders) is equal to what the company has minus what it owes. Before we talk in a bit more details about each part of a balance sheet, here is an example one:

Sample Balance Sheet
Assets Liabilities and Owners’ Equity
Cash £6,000,000 Liabilities
Intangible assets £4,000,000 Notes Payable £5,000,000
Tools and equipment $25,000,000 Accounts Payable £22,000,000
Total liabilities $27,000,000
Owners’ equity
Capital Stock $7,000,000
Retained Earnings $1,000,000
Total owners’ equity $8,000,000
Total $35,000,000 Total $35,000,000

Real world balance sheets of companies will be more complicated of course, but this example should give you a good idea what to expect. The next important thing to understand is what these numbers mean and what should we expect from a good company:

Assets:

There are two kinds of assets. Current assets and long term assets. The current assets are what is expected to be easily sold during given financial year. If the company has to meet some financial obligations, it can use it current assets to cover for that. These usually include cash, cash equivalent, short term investment, stock inventory. These usually are well reflected on the balance sheet.

Non-current assets are the assets that can’t be easily converted into cash to meet financial obligations. They include machinery required to produce goods, real estate, biological assets (if the company sells milk, these could be cows…) and other similar things. Value of these things sometimes can be misleading on the financial statement.

All what we have discussed so far constitutes tangible assets. Tangible assets, are the ‘material things’ that have value easy to describe/imagine. However, on the balance sheet we will also often find different intangible assets. These are needed, because no-one will argue, that if a company just spent 100 million pounds on advertisement, this is not worth anything? Or if your company is called Coca-Cola? Or if you have just finished creating a software that took your company 4 years to build? All these things are intangible assets. Everyone agrees that in the modern world, intangible assets on balance sheet are needed, but they are often suspect to being abused. Maybe the advertisement was a complete flop? The software is not working as intended, or competitor already cornered the market with better cheaper product? If you find a lot of intangible assets on any balance sheet- investigate what are they first!

Liabilities:

This is what the company owes. It includes all sort of payables, (accounts, salaries, sales, notes), both long term and short term debt. High level of debt, especially short term debt could be very dangerous for the company survival. In the end we will look at important ratios based on these concepts.

Owners Equity:

This is effectively the value left for shareholders. This is also sometimes referred to as the ‘book value’- how much the company is worth just based on its figures from the balance sheet. Usually the market value is greater than that, because it takes into account future earnings and other factors.

Which ratios are useful?

There is a quite a number of important ratios that you can derive from balance sheet (or find pretty much anywhere online). Here We will look at the key ones:

  • Book value per share – How much of book value is associated with each share? Useful to know if you are getting a bargain.
  • Tangible book value per share – How much of tangible book value is associated with each share? If you do not trust the intangibles, this could be interesting measure for you.
  • Current Ratio – It is calculated by dividing current assets by current liabilities. Absolutely critical measure. It is calculated by dividing current assets by current liabilities. This means, that it checks if the company can quickly get enough cash to pay its debts that are due. If this is below 1.0 – this means that the company could be at risk of going bankrupt. Most people suggest that safe values start from around 2.0 (twice as much money as it is needed to pay the debts that are quickly due).
  • Quick Ratio – Similar to current ratio, but this excludes inventory from the assets. Meaning that this shows, if the company can cover the debt if it has to do it really quickly (hence, quick ratio). It can be useful in special cases, but in general current ratio is believed to be more useful.
  • Price to book ratio – It is variation of book value per share, but it takes the whole valuations, so it is easier to plot it. Price to book ratio of 1 means that market price of the company is the same as book price. Below 1 means that market values it less than a book (balance sheet)- which can mean either trouble, or bargain. Value above 1 is quite standard and shows you how much premium ‘the market’ gives to the company.

Congratulations on reaching this far. The part 2 will come soon. Let us know what else you would like to read about in the comments!

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