How do you go about investing in stocks? Obviously, the first thing to do would be industry analysis - growth prospects, competitive analysis, barriers to entry, etc. But, as we had quoted Warren Buffet in a previous article, “there is a lot more to picking stocks than to work out which is going to be the most wonderful industry in the future.”
We won’t believe you if you said that you analyzed a company without interpreting its balance sheet. It’s one of the crucial aspects of stock picking. It may not give you spectacular gains, but as Peter Lynch notes - “The greatest losses in stocks come from companies with poor balance sheets.” So, now you know.
But then, how to analyze a Balance Sheet, you ask? Well, we’ve got you covered. First of all, let’s get the basics straight.
What is a Balance Sheet?
A balance sheet is a statement of the financial position of a company that reports its assets, liabilities & shareholders' equity at a specific point in time and provides a basis for computing rates of return and evaluating its capital structure. It is a statement that tells you what a company owns & owes, and how much the shareholders have invested. Or you could sum it up in this equation -
Assets = Liabilities + Shareholders’ equity
Financial statements such as Balance Sheet, Profit, and Loss accounts, Cash Flow Statements, etc., reflect the company’s financial position and performance in terms of profitability & liquidity.
Now that you know what a balance sheet is, let’s understand its five components that can influence your investment decisions.
Debt represents the borrowed funds or the long-term borrowings section in the balance sheet. These are the funds that a firm borrows from banks, financial institutions, or any other sources for a fixed period of time which is more than a year, at a fixed rate of interest that is to be paid at the time of repayment.
It is usually interpreted that if the company has borrowed a considerable amount of fund which needs to be refunded at a specified future date, the risk of investing in such an organization can be high. However, if the amount of borrowed funds is less, it may be safe on the part of the investor.
Free reserves are created for any contingencies which may arise at any point in time for which the firm might have to withdraw funds. It could also be used for investments. The company might even decide to declare dividends, issue bonus shares, write accumulated losses from such reserves.
The amount of free reserves that a company has accumulated is directly related to the firm’s liquidity position over a while.
Suppose these free reserves are not used for paying dividends or declaring a bonus. In that case, they might be utilized into making new investments in Plant and Machinery or other profitable projects, which will bring in better efficiency and profits for the company and hence better returns for the people who have invested in the firm.
Investments are the areas or instruments wherein a company invests its idle money to either get higher returns or for growth. They can be for a short period, that is, for a year or a long term, ranging from 3 to 5 years or even more.
The firm’s investments indicate the company’s inclination in different sectors and are a key to judging whether it is planning to grow or even diversify its business going ahead. Whether through acquisitions or by self-expansion & diversification, how the company is planning to expand must be taken into consideration.
Contingent liabilities refer to the liabilities which may or may not arise in the future and depends on the happening of a particular specified event. It a liability or provision created for a potential loss that the company might have to bear. For example, product warranties, expenses on pending investigations, potential lawsuits, etc.
Usually, companies maintain a separate account under the notes to financial statements for such contingent liability expenses which may arise. The main idea is not to disturb the normal operations of the business and meet such obligations smoothly.
Pending litigations must be taken note of. They tell you that the company may have shell out money in the future and indicate that there could be a probable disturbance in the company’s normal operations. Moreover, it could also mean that the industry itself is quite uncertain and subject to regulatory risks.
The capital required to carry out the business’s day-to-day operations is referred to as the working capital. It is the net current assets that the company has after subtracting the firm’s current liabilities, which is needed to repay. It’s not directly noted in the Balance Sheet, but a simple calculation can help you derive the Working Capital:
Working Capital = Current Assets - Current Liabilities
The liquidity of any company is related to net current assets it has; that is, the firm’s working capital should always suffice the firm’s operating expenses, or else it might have to undergo liquidation.
Therefore, the working capital should always be enough to cover the expenses or more than required to be on the safer side.
No denying, the Balance Sheet is an important metrics to take into consideration while making investment decisions. It gives you an idea about certain things that could go wrong in the company going ahead. However, it should not be the sole deciding factor for any stock-picking because there’s much more to a company than its Balance Sheet.
As Henry Ford once said, “The two most important things in any company do not appear in its balance sheet: its reputation and its people.” Besides, many other factors have to be considered, namely its moat, unique value proposition, the stickiness of its offerings, switching costs in the industry, etc.
Hence, it’s always advisable to pay due attention to all the aspects of a company before putting your hard-earned money into it. Because, as Peter Lynch says, and we quote -
“Know what you own, and why you own it.”