Saturday, February 5, 2011

How to Read Balance Sheet for Stock Analysis

1. What is Balance Sheet Analysis?
2. What are the main components of Balance Sheet?
3. How Balance Sheet is Make-Up?
4. To which areas do the Balance Sheet Analysis concentrates?

Balance sheet analysis assesses the financial strengths and weaknesses of the company primarily from the point of view of the shareholders and potential investors, but also as part of management's task to exercise proper stewardship over the funds invested in the company and the assets in its care.

The three main components of a balance sheet are:

    Assets = what the business owns;
    Liabilities = what the business owes; and
    Capital = the owner's interest in the business.

The balance sheet equation
    The balance sheet equation is:
                                               Capital + Liabilities = Assets.
    Capital plus liabilities comprise where the money comes from, and assets are where the money is now.


    The balance sheet contains three major sections:

   1.Assets or capital in use divided into the following:
     * Long-term or fixed assets which the company owns and needs to carry on its business: land and buildings; plant and machinery; fixtures and fittings; and motor vehicle fleet.
     *Short-term or current assets which change rapidly as the company carries on its business stocks of raw material; work in-progress; stocks of finished goods; debtors; bank balances and cash. The heading current assets covers an important operating cycle within the company, which is vital for both profitability and liquidity.
      In this cycle, cash flows out of the business up to the point where the customer, or debtor, takes delivery of the finished goods. When the customer pays, cash flows back, and if the goods yield a profit, current assets increase.
   2. Current liabilities, the amounts owed which will have to be paid within 12 months of the balance sheet date. These will be shown under the heading of creditors in the balance sheet and will include tax, bank overdraft and dividend payments due to shareholders.
   3. Net current assets or working capital, which is current assets less current liabilities. Careful control of working capital lies at the heart of efficient business performance.
   4. Sources of capital, comprising: 
        * Share capital;
        * Reserves which include retained profits, which are distributable, and any funds in the share premium account (money paid in by shareholders over and above the nominal value of the shares they hold) which are non-distributable; and
        *Long-term loans.


    Balance sheet analysis concentrates on two areas: liquidity and capital structure.

Liquidity analysis

    Liquidity analysis aims to establish that the company has sufficient cash resources to meet its short-term obligations. The key balance sheet ratios used in liquidity analysis are as follows:

   1. The working capital ratio (current ratio). This relates the current assets of the company to its current liabilities and is calculated as:
             Current assets  /     Current liabilities
            There is no categorical rule of what this ratio should be but, clearly, if it is less than 1, there may be danger because the liquid resources are insufficient to cover short-term payments. However, too high a ratio (say more than 2) might be due to cash or stock levels being greater than is strictly necessary and might therefore be indicative of the bad management of working capital requirements.The working capital ratio is susceptible to 'window dressing', which is the manipulation of the working capital position by accelerating or delaying transactions close to the year-end.

2.The quick ratio (acid-test ratio). The working capital ratio includes stock as a major item and this may not be convertible very readily into cash if the need arises to pay creditors at short notice. The quick ratio, as its name implies, concentrates on the more readily realizable of the current assets and provides a much stricter test of liquidity than the working capital ratio.
The quick ratio is calculated as: Current assets minus stocks/ Current liabilities

        Again, there are no rigid rules on what this ratio should be. But it should not fall below 1 because this would mean that if all the creditors of a company requested early payment there would be insufficient liquid, or nearly liquid, resources available to meet the demands. The company would fail the 'acid test' of being able to pay its short-term obligations and would therefore be in danger of becoming insolvent. The seriousness of the situation would depend on the availability of loan or overdraft facilities.

Capital structure analysis

        Capital structure analysis examines the overall means by which a company finances its operations. Companies are usually financed partly by the funds of their ordinary shareholders and partly by loans from banks and other lenders. These two sources of finance are referred to as equity and debt respectively, and the relationship between the two indicates the gearing or leverage of the company.

        The higher the proportion of debt to equity, the higher the gearing ratio, i.e., a company is said to be highly geared when it has a high level of loan capital as distinct from equity capital. The problem, which can arise from high gearing, is that providers of loan capital have priority for payment over shareholders and, in hard times, the latter might suffer. On the other hand, gearing provides the benefit of a predictably fixed amount of interest every year, and the priority given to providers of loan capital over shareholders on liquidation should make the cost of debt capital less than that of equity. The gearing position of a company can be assessed by the use of the following balance sheet ratios:

   1. Long-term debt to equity ratio. This is the classic gearing ratio and is calculated as:
( Long-term loans plus preference shares /  Ordinary shareholders funds)*100
   2.Long-term debt to long-term finance ratio. This ratio calculates the amount of debt finance as a proportion of     total long-term finance as follows:

      (Long-term loans plus preference shares/Long-term loans plus preference shares
      plus ordinary shareholders funds)*100

          The implications of this ratio are similar to those of the long-term debt to equity ratio. The higher the ratio, the higher the proportion of debt in the capital structure of a company and therefore the higher the amount of the interest charges that might be expected.

          There is no such thing as an optimum ratio. It depends on circumstances. But a company with a low level of business risk with stable operating profits may be able to withstand higher gearing than a company whose operating profits fluctuate widely.
   3. Total debt to total assets ratio. This ratio shows the proportion of the total assets of the company that is financed by borrowed funds, both short term and long term. It is calculated as:
                                                  Long-term loans plus short-term loans
                                                  --------------------------------------    X 100
                                                                        Total assets

        The total debt to total assets ratio recognizes the fact that short-term bank loans and overdrafts are often almost automatically renewable and are therefore effectively a source of long-term finance. Again, this ratio gives an indication of the extent to which interest payments will have to be made.


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