One of the most important things to look at is the balance sheet whether you plan to buy a stock or already own some stock.
The balance sheet gives a lot of information about the company that you can understand and analyse, get a view of its financial health and decide whether you want to own the stock.
Let’s look at a few factors that you should look at in the balance sheet that will help you make an informed decision.
As you probably know the balance sheet has two parts – assets and liabilities. Assets are what the company uses to run the business and liabilities support the assets. The assets should be equal to the liabilities. Some analysis into the various figures reported in the balance sheet will help one to find out the financial standing of the company.
There are certain ratios/numbers that one can calculate to find out the company’s status and help you decide if you want to own a part of the company.
- Working Capital ratio- It is defined as the ratio of Current Assets and Current Liabilities. If the ratio is less than 1, it means the company does not have enough assets to cover its short-term debts. It could also mean that there are operational inefficiencies in terms of sales decreasing or amounts not getting paid by /collected from clients or mismanagement of inventory. On the other hand if the positive difference is very huge also one should be alert as it may be high if excess cash is lying idle with the company, which is not such a good sign.
- Return on Assets Ratio – This is the ratio of the net income the company is earning and the average total assets. The higher this ratio, the more efficient is the management of assets. This figure should be compared with peers as well as with past performance.
- Debt-Equity Ratio – It is defined as the ratio of total liabilities and Shareholders’ Equity. It shows how much debt the company has. If this ratio is greater than 40%-50%, then more analysis is required in terms of studying the financial statements carefully and looking at the numbers of the peers, as it is an indication of some financial stress. Here again, the type of industry has to be considered. For a capital-intensive industry, the higher numbers may be justified initially as capital requirements are high initially but a rising trend of this ratio for a company in this industry is a case for more scrutiny.
There are more numbers and other information in the balance sheet to understand which we would cover in a later article. We hope that this has given you a starting point to understand the balance sheet of a company in which you would like to invest.
If you are a shareholder of a company, it is important that you understand how the balance sheet is structured and how to read and analyze it. Some numbers from the balance sheet that give information about the financial status of the company are –
- Working Capital Ratio
- Return on Assets Ratio
- Debt-Equity Ratio