Investing in equity is probably the best bet if you have a reasonable risk appetite and adequate staying power to continue with your investment. Investing in stocks is any day a great investment option as the returns are much higher than bank deposits. But investing in equity is an informed decision making. You need to put in a lot of thought before you buy stocks. Unless you are aware and have weighed all the future prospects of the growth of the stock, it could take you for a ride given that stock market is highly volatile and subject to bullish and bearish movements.
But then, you don’t have to be too afraid if you equip yourself rightly with the tools and techniques of analysis. Yes, you read it right, analysis is the key. Equity investment is NOT speculation but a well analysed decision and there are ways of analysing and valuing the company to make the right choice to park your funds.
And what better way to do business valuation than a balance sheet analysis. The financial statements drafted and certified by the appropriate authority is the most authentic source of information available for you to know the financial details of the company.
But it is not as easy as it sounds. Reading a balance sheet does require technical expertise and some calculations to make sense out of the numbers provided to us. But just take a chill pill, because, you need not have to be a number cruncher to be able to do this. Sit down with a balance sheet and calculator and sincerely try to understand the statements. It will eventually start making sense to you. I am giving you some points to keep in mind, while doing the analysis, to ensure that your balance sheet analysis is adequate and serves the purpose for you.
1. Begin with the end in mind.
Now that’s Stephen Covey quote. But it is apt here! The purpose of balance sheet analysis is to be able to pick the right stock. Precisely, finding the intrinsic value of the shares of the company that are most likely to appreciate in the future and add to our capital investment. Therefore it’s imperative to pick the most relevant details to craft out the ratios and averages to determine the share value.
2. Picking up the right ratios for determining asset performance.
Now, there are two jargons here. Ratio’s and asset performance.
Asset performance means how much return on the assets the company is able to generate in a particular financial year. That determines how the revenue generated can be spread over the average fixed assets of the company. If the company is capital intensive, then your fixed assets number could be huge and a major determining factor in determining asset performance.
But if you are still wondering why we need to analyze the asset performance, it is to find out how efficiently the company is utilizing its fixed assets. That’s a precursor to understanding what they will do if you and I give them more resources in the form of investment in the company shares. The more the company is productive in utilizing its assets in sales generation, better is the company’s performance. If the company is capital intensive and has more fixed assets, Investors should look for high fixed asset turnover ratios and preferably greater than 1, to start with. For other companies, return on total assets would be ideal as an indicator to asset performance.
3. Determining the working capital position.
Working capital position is most crucial in valuing a business. It determines the company’s efficiency in both inventory as well as accounts receivable. The operating cycle of the company is that which quantifies the time taken by the company to convert stock into accounts receivables and realize it to bring in cash into the business, this will determine the managerial efficiency of the company. Managerial efficiency may be qualitative and not measurable from balance sheet directly. But if you find the operating cycle of the business to be favorable then be rest assured that the company is in safe hands and in turn your money.
4. Watch out for Intangible Assets.
The non physical assets present in the balance sheet like goodwill could possibly confuse you if you don’t rightly deal with them. Goodwill could be a purchased goodwill and are usually deducted in calculating the tangible net worth. Look out in the notes to financial statements as these are not apparently disclosed in the statements.
Hope this write-up gives you a fair idea about how to go about reading the balance sheet.With time and consistent quest for knowledge. you are sure to become a wise investor. Let me know how your experience was, analyzing the financial statements.