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Fundamental Analysis: Balance Sheet

Sunday, February 14, 2010

A company's balance sheet is a record of its assets and liabilities.  Basically, if we look at how much the assets are worth and deduct the total value of the liabilities, we will arrive at the net worth of the company.  Net worth or the book value of the company is also known as shareholders' equity.

Under assets, first, we see Current Assets.  Current Assets are cash and other assets which can be converted into cash within a very short time.  Usually, they are listed in the balance sheet in order of liquidity with cash being the first item as it is the most liquid.  Secondly, we have Non-current Assets.  These are assets which cannot be converted into cash within a very short time.

One thing that value investors look out for is how much cash and cash equivalents a company has.  Having a lot of cash is usually a sign of strength.  The company will have the ability to seize business opportunities and will be able to go over rough patches in the business cycle relatively intact.

Next on the list is inventory or the goods which are in the company's warehouse which it sells to customers.  In business, we say that we cannot do business with an empty wagon.  Our wagon has to be stocked and that's our inventory.  However, we do not want our wagon to be overstocked as well.  Goods also run the risk of becoming obsolete in many cases.

Accounts Receivables is next.  When the company sells goods to its customers, very often, the customers are given credit terms.  In businesses which have a strong retail bias, this might be a very small amount if it exists at all since they collect cash for all their sales.  We want to keep an eye on this because if most of a company's Current Assets are in Accounts Receivables, we have to question the financial health of its customers and how long does it usually take before payments are made.

Prepaid Expenses or payment in advance is next.  I like this because it shows that customers are willing to pay in advance before they receive the goods.  It shows that the company's products are in demand and, probably, cannot be replicated or very difficult to replicate by its competitors.  The company has a competitive advantage.

Next, we move on to Non-current Assets.  Companies might own properties, vehicles and production equipment.  Vehicles and production equipment will depreciate in time and the value we see in this line is the total value at the time the balance sheet was prepared minus depreciation.

Then, we have goodwill.  This is something which has been discussed in the case of Healthway Medical.  This number appears when a company buys over another company at a price above the latter's book value.  The value above the book value ends up as goodwill in the former's balance sheet.

This is followed by other intangible assets which cover copyrights, patents, trademarks and so on.  Only intangible assets bought from another company can be reflected in a company's balance sheet.

Both goodwill and other intangible assets must be amortised over time if they have a finite life.  If they are not depreciating in value over time, then, they need not be amortised.

Long Term Investments are next.  This shows any investments a company might have made which have durations of longer than a year.  We will have to dwell on this a bit more to see what kind of investments have been made here as and when it occurs.  It will differ from case to case but generally, we want to see that these are investments which generate higher returns for the company.

An important ratio we use in fundamental analysis is Return on Assets (ROA).  This is a measure of the level of efficiency in which a company utilises its total assets.  If we take net earnings and divide this by total assets, we get a figure in percentage terms.  The higher the better.

We move on to Liabilities and just like Assets, there are Current and Non-current forms.  First off under Current Liabilities, we have Accounts Payable which is money owed to suppliers for goods and services provided.

Then, we have Short Term Debt or Debt which is due.  If a company has a lot of Short Term Debt, this could be dangerous in times when credit is suddenly difficult to come by.

To calculate the financial health of a company, analysts employ the Current Ratio which divides the total Current Assets by the total Current Liabilities.  So, you can imagine that if you have more of the former and less of the latter, it's a good thing.  A more stringent ratio is the Quick Ratio and it measures a company's ability to meet its short term obligations using its Current Assets minus Inventory.  Any ratio value of more than 1 is good.

Under Non-current Liabilities, we have Long Term Debts and so on.  I guess the important thing to say here is that very strong and long established companies which generate healthy cash flow usually have very little debt.

I think it is common sense that we want to see as little debt as possible in a company's balance sheet but debt is sometimes a necessary evil.  So, we have to evaluate debt on a case by case basis.

I hope this quick introduction to what is a Balance Sheet and how to use certain ratios to determine the health of a company is useful.  Next post will be about the Cash Flow Statement.

Related posts:
1. Fundamental Analysis: The Income Statement.
2. Recommended books for Fundamental Analysis.

13 comments:

1911 said...

AK, I really appreciate your write-up on reading financial statements. It will be more great if you can use an actually financial statement from company ABC or XYX as an example. That will really help me to understand better.

Great work! Keep it up!

AK71 said...

Hi 1911,

I am glad you like what I am doing. :)
Musicwhiz does a great job of doing exactly what you are suggesting I do next. He looks at the financial statements of companies he is vested in and explains his observations usually in great detail. You can find a link to his blog in my blogroll, "Traders and Investors".

You might also want to pick up a book on the reading of financial statements. The book which describes how Warren Buffet does it is very easy to read and you will find it in the top right corner of this blog in the box that says "Books I've read".

Have a great week ahead and come back often.

Robin Lim said...

AK..you are doing a good job. Very interesting reading. I read yr comments about saizen and they are good. But i hv always been concerned about japan's debt/gdp. An article in Forbes Feb issue p62 "Blowup" explained it well. Be careful about Japanese property, because it can be a Greece.

Anonymous said...

Dear AK71

Happy New Year. May this be another prosperous and successful trading year for you and all the readers of this blog.

Its me, Blackbird seeking your opinion again.

I encountered some bad trading sessions during the last 2 Ox weeks and got terribly burnt for forcing some contra trades which were based mainly on price movements and gut feel. Wrong moves which cause some $14k losses.

I am now monitoring again the market and understand why you use MFI quite frequently. Now after today run up closing @$2.13, Indofood MFI appears to be touching the 70, close to 60days MA. It seems to me the counter is now on uptrend again. How can I confirm it and and re-enter the mkt?

Similarly for Straits Asia, the counter closed @$2.21, nearing its 90days MA. The MFI is about 50plus. Shows some uptrend signal. Do you think I can try to nimble on this counter again? Pls enlighten me. Thanks.

Regards

Blackbird

AK71 said...

Hi Robin,

Thanks for the compliments. :)

Japan does have a debt problem but we have to remember that Japan is not only a borrower, it is also a lender. Japan is the second largest lender to the USA. China is of course the largest.

I have not read the article in Forbes but did they look at debt as a percentage of GDP only? Another way of looking at this is debt per capita. In this respect, Greece is number one in the world at US$ 27,746. USA is 11th at US$ 11,094. Japan does not even come close.

I blogged about this earlier in the year:

http://singaporeanstocksinvestor.blogspot.com/2010/01/new-year-and-new-decade-strategy-for.html

If you have the URL to the Forbes article, please share it here. I would like to read it. Thank you. :)

AK71 said...

Hi Blackbird,

Happy New Year. :)

MFI is a momentum oscillator and is used very much like the RSI and the Stochastics. They are more accurate in a trendless situation. Basically, if these are in oversold territory, there is a higher chance of an upturn.

IndoAgri had a nice run up today on very high volume. We have a bullish crossover on the MACD. MFI is rising but has not gone into overbought territory. It looks like there might be a follow through tomorrow and the price might go higher. I see gap resistance at $2.30. I don't like to chase. I like to buy when something is oversold or close. It's up to you.

As for Straits Asia, very similar signs as IndoAgri and might go higher. Price closed at the dead cross formed by the 100dMA and the 20dMA today. This is a strong resistance and if it overcomes this, I see gap resistance which more or less coincides with the 50dMA at $2.36. Again, I don't like chasing. You will have to decide. Good luck. :)

Lance said...

i really enjoy reading ur blog...
im still learning and i find this a great platform :-)

keep up the good work

AK71 said...

Hi Lance,

I am glad that you have found my blog useful. Honestly, I am still learning too. Thank you very much for the encouragement and do visit often. :-)

sy sy said...

hi mr ak

sorry to hijack this thread.
me tried to search from ur blog, but I can't find any post related to skill future.

I am a new to ur blog and also new to investing in stock market.

since government helping & encourage me to upgrade myself, so I am thinking to use the skill future fund to learn something related to investing :)

*** free $, don't waste ***

problem is I don't know what types of courses suitable to me as beginner.

so I hope u can help to give some advise and/or recommendation on types of short courses that is suitable for a beginner investor in stock market.

many many thanks ;)

AK71 said...

Hi sy sy,

I am not in the know when it comes to the Skills Future credit scheme.

You will have to visit the WDA website to find out more. Here are the courses you could look at: WDA Course Directory.

To learn more about investing, you could start by reading books and I have listed some in my blog's right side bar under the heading "Food for thought". Happy reading! :)

sy sy said...

Hi

thanks for advise.
Actually I already ordered some books from better world.
It status show shipped since 21Jun.
Already 1 month liao, haven't receive.... :(
Wonder the books will get lost or I lost the $ that I paid for my books.... sigh

AK71 said...

Hi sy sy,

They consolidate various orders into a single cargo before shipping to the destination. The cargo is sorted in Singapore and the various orders sent out by local handlers to customers. This is a greener and cheaper solution but it takes longer.

To be sure, you might want to send them an email to check on the status.

AK71 said...

Reader:
Morning AK😊 pls advise how do u derive NAV? Any formula?

Investopedia says:
When the total value of assets is added up, liabilities are subtracted and the remaining number is divided by the number of outstanding shares; the resulting value is referred to as the net asset value (NAV).
Source:
http://www.investopedia.com/walkthrough/fund-guide/introduction/1/net-asset-value-nav.aspx

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