Basics of stock market investing – part iii

Balance Sheet Fundamentals

Welcome to the 3rd series of stock market investing.  Maybe there is a company you have had in mind to invest in but not sure if it is the right move to make.  By performing balance sheet analysis of this company and then comparing this company to its peers, you move a step closer to deciding if it is a good stock to buy. Balance sheets provide a snapshot of how a business stands at any point in time i.e. how the assets it owns are financed by liabilities it owes and equity it retains.

Assets are broken into current assets (i.e. assets easily convertible to cash within one year) and non-current assets i.e. assets not easily convertible to cash.  Some companies have a heavy non-current assets balance due to the nature of the business e.g. investment in property, plant and equipment while others are heavily weighted against current assets e.g. finance / lending companies.

Liabilities also have 2 categories: current liabilities are due and payable within one year e.g. accounts payable due to suppliers while non-current liabilities are more longer term obligations e.g. long term debt owed to the lending institution.

Finally, to balance out the equation, we have the shareholders’ equity section of the balance sheet which is the difference between total assets and total liabilities i.e. it shows how else the company is funded besides through debt e.g. capital raised from investors / shareholders in the stock market including funds the company has ploughed back into the business from operations.

A quick pulse to take on a company is measuring the quick ratio and current ratio i.e. the measure of a company’s ability to meet its short-term obligations with its most liquid assets.  The higher the ratio, the better the pulse of the company.   Quick ratio = current assets – inventories / current liabilities while current ratio is current assets / current liabilities.  A debt-to-equity ratio (“DTE”) is another pulse to take on a company.  Basically, a high DTE ratio signifies that the company is highly leveraged i.e. it is financing its operations with a lot of debt which may not be a good thing if not managed properly.  A company should ideally finance its operations in the following order: 1). cash generated from its operations; 2). financing from equity investors 3). debt financing.

The balance sheet only provides one aspect of a company.  You will need to do more analysis of the company’s income statement and cash flow statement to obtain a trend analysis of how well the company is performing over time.

In the next series, we’ll delve into income statement analysis.  In the interim, if you have not viewed part i and ii of this series, Click here for link to part i and here for link to part ii.

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