Using the Accounting Balance Sheet When Value Investing
A company financial statement explained!
The accounting balance sheet, or statement of financial position
, forms part of the annual stock report. It provides important information for value investing.
The function of balance sheet reports is to provide a snapshot in time of the company's liquidity and solvency.
Examples of balance sheets are found in company annual reports that can be obtained online from company websites.
I suggest you use a basic balance sheet example from a small company's report to follow this discussion and identify the various parts. Balance sheets can be found in company annual reports on company websites.
Understanding balance sheets requires knowledge of balance sheet basics that are provided below.
Balance Sheet Parts
The assets part tells you what the company owns. This is divided into two sections.
The current assets section tells you how much cash (liquid assets) is available together with how much can be converted into cash within a year.
Additional assets or non-current assets including investments, property and plant and accounting goodwill are added to the current assets to give total assets.
Below the total assets are listed the items that tell you something about the company's liquidity. These are the current liabilities.
A company whose current assets do not meet their current liabilities has a liquidity problem.
Accounting balance sheet ratios include the current ratio which is the ratio of current assets to current liabilities and measures liquidity. A current ratio greater than one is desirable.
This ratio allows easy comparison with other companies. A current ratio that is trending higher over the last several years is good, but if it heading south it is not so good.
Working capital, which is current assets less current liabilities, can be a source of funding, but is not long-term.
Underneath the total current liabilities are listed the non-current liabilities including the long-term debt. Current and non-current liabilities are added together to give the total liabilities.
Long-term debt is any interest-bearing debt not payable within one year. Long-term debt is the other major source of capital for a company beside shareholders equity. I prefer to see long-term debt no greater than four times net profit.
Shareholders' Equity is the capital invested from shareholders through their shareholdings, together with retained profits; that is, profits not distributed as dividends. Shareholders' equity is equivalent to book value.
The ratio of long term debt to shareholders equity is called the debt to equity ratio. It is a measure of the solvency of the company.
A debt to equity ratio above 40% could spell danger of excessive debt. It could, however, relate to the funding of a recent acquisition which might enhance future earnings.
A company that is able to borrow long-term at cheap rates and generate high returns on their debt is using debt wisely.
Companies with a high return on capital (ROC) or return on funds employed (ROFE) (debt plus equity) are examples of companies that succeed in this respect. They are companies that investors using a value investing approach like to find.
Total liabilities, together with shareholders equity balance total assets. Hence the name balance sheet.
The key areas of the balance sheet that I keep track of are in bold face above. Hop up and have another look. There are three of them: the current ratio, long-term debt and debt to equity ratio.
You don't need to calculate current ratios and debt to equity ratios. They should be obtainable on your online brokers website. If they are not? Find another broker!
The importance of too much debt has been illustrated by the recent global economic recession. Checking long-term debt and debt to equity ratio helps value investors to avoid risky companies
A concern for value investors like me is that the fair market value of many assets can be very different from the 'book values' shown in the accounting balance sheet statement. This particularly applies to companies like real estate investment trusts (REITs)
So investors following a value investing approach need to do more research, beyond reading an accounting balance sheet.
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