Balance Sheet: Investors Guide To Equity Investment

While talking about investments, analyzing a balance sheet naturally pops up in the mind of ace investors. In this article, Geyatee Deshpande highlights why the balance sheet is considered to be an integral part of cash management 

The corona virus pandemic saw investors stressing about the financial health of companies and banks and emphasizing on the necessity to carefully scan balance sheets. And hence, recently there has been a lot of buzz going on about the ‘balance sheet’. This has highlighted the biggest difference that separates experienced investors from others. A novice investor tends to make the mistake of investing in equity only by looking at stock movements whereas experienced investors consider analyzing a balance sheet as an important point before making any investment. Is it necessary to study a company’s balance sheet? What will I achieve from it? Do balance sheets really matter? 

Such questions are quite common from novice investors. And the answer to all these questions is ‘yes’. Balance sheets may look like those tedious ‘terms and conditions’ marked with asterisk in a document that we feel okay to skip but according to Pranav Damle, an avid investor investing for more than seven years, “Balance sheets are like the ‘terms and conditions’ marked in asterisk in a document that can save you from taking unnecessary unknown risks if you have a careful look.” The basic purpose of a balance sheet is to give interested parties an idea of the company’s financial position, in addition to displaying what the company owns and owes. It shows a real overview of the business and its overall health, not just how it performed within a certain period.

Generally, when valuing a company or considering an investment opportunity, analysts prefer to normally start by examining the balance sheet. According Russell Sherman, an American classical pianist, educator and author, “A work of art expresses itself as a balance sheet pitting the spoken against the unspoken.” It is commonly said that ‘numbers don’t lie,’ and that is very accurate in case of financial analysis than anything else. While balance sheets are important for multiple reasons, the most common include: when a merger is being considered, when a company needs to consider asset liquidation to prop up debt, when an investor is considering a position in a company and also when a company looks inward to determine if it is in a stable enough financial situation to expand or begin paying back debts.

Assets

Assets are an important part of the balance sheet which investors generally tend to focus on. The balance sheet highlights the current assets of a company. An asset is considered current if it can be easily converted into cash within generally a period of one year. Most common examples of it include cash, inventories and net receivables as they are important current assets because they offer flexibility and solvency. Assets also help to understand the company’s capability to think about its future and long-term investment goals. Long-term capital investments including everything right from factories to patents to investments in other companies gives an indication of the company’s foresight and efficiency.

Even as cash is undoubtedly the most important point of focus, assets also includes a lesser focused at category of intangible assets. Intangible assets generally include intellectual property, at times referred to as identifiable intangible assets and goodwill that is also known as an unidentifiable intangible asset. Intellectual property includes things like patents, licenses, copyrights, trademarks and customer lists. Intangible assets play an important role during mergers and acquisition. Goodwill is an asset that comes handy when one company purchases another. Goodwill appears when one company purchases another at a price that’s higher than the value of all that company’s tangible assets. Majority of the times, a common reason for the purchase price to be higher than fair value is because a company already has a recognizable brand name or a strong customer base.

"We always look at the margin of safety in the balance sheet and then worry about the business."

-Peter Cundill, Canadian value investor

Liabilities

If assets are important to help you understand the condition of the company and sustainability then liabilities helps you point out the red flags. Current liabilities are considered to be obligations due within a year. And hence investors are always especially when compared against cash flow. Companies that owe more money than they bring in are usually considered to be in trouble. In such a case their sustainability in the sector in times of crisis is heavily questioned. Additionally, debt is a most sought after item in the liabilities section.

While borrowing money and using it for growth purposes is a good idea, the strength of the company to engage in debt reduction is cheered by investors as it leads to much stronger and healthier balance sheet. Along with assets, liabilities are also important as debts and other liabilities must always be settled before booking a profit. Balance sheet also aids in calculation of ratios such as the quick ratio, the working capital ratio, debt-to-equity ratio, etc. which assists investors in making better and safe investment decisions.

"Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets."
-Peter Lynch, American Investor, Mutual Fund Manager & Philanthropist

"We will reject interesting opportunities rather than over-leverage our balance sheet."
-Warren Buffet

Shareholder Equity

Shareholder’s equity is the highlighting part for equity investors. It is the money that goes to a company’s owners or shareholders and is calculated simply by subtracting liabilities from total assets. It also gives the company’s net income, net worth and overall value and so considered as an important number to investors because you can see the company’s worth. More equity generally means more money for shareholders to claim to. This is generally given in the form of dividends. A company can pay out all the money to its shareholders, but ideally companies prefer to reinvest the money in the company. Under the equity section, investors should pay particular attention to retained earnings and paid-in capital.

This number shows the amount of profit the firm reinvested or used to pay down debt, rather than distributing it to shareholders as dividends. An ideal company strikes a perfect balance between giving out dividends to its generally and also retaining a part of money. The equity section also shows the value of paid-in capital and stocks. Common stock is what generally all people get when they buy through the stock market while preferred stock gives shareholders greater claim on company’s assets and earnings. This is important because in case of liquidation i.e. when a company is about to down its shutters forever and liquidate all of its assets, the value would go first to preferred stock holders and then to common stock holders.

Jitendra Upadhyay, Equity Research Analyst, Bonanza Portfolio Ltd.

While investing in any stock you need to check the analysis of financial ratios to find out the company’s true value. This is normally done by examining the company’s profit and loss account, balance sheet and cash flow statement along with various financial ratios. Believe that the most important areas on a balance sheet are cash, account receivable, short-term investment, property, plant and equipment, short-term debt and long-term debt and other major liabilities. 

Mid-cap and small-cap companies with strong balance sheet such as SIS India, Burger King, Mahindra Logistics and Cyient are likely to gain in terms of market share and likely to be re-rated in near. For example, SIS India’s net debt declined to 3.2 billion as of March 2021 from 5.9 billion as of March 2020 and this was mainly due to slower growth that resulted in less working capital requirement and supported by very strong collection. It had OCF/EBITDA of 123 per cent for 2021. This group generated total operating cash flow of Rs 6.4 billion in FY2021 as against Rs 2 billion in FY2020.

As for Burger King, Q1FY21 and Q2FY21 results were disrupted by shutdown of stores during the lockdown period in India. BKIL has an operating leverage business model; the company has negative working capital. Cash generated from operating activities improved from negative Rs 30.5 crore in FY2018 to Rs 112.7 crore in FY 2020. In FY20 the D/E ratio is comfortable at 0.8x. The amount raised through equity issuance will be utilised for repaying the entire debt on books and the company’s plan to open 700 restaurants by 2026. Strong store expansion plans would help in improving growth prospects in the coming years.

Conclusion

With help from the three sections – assets, liabilities and equity – a company’s balance sheet provides meaningful and valuable insights into its health and dealings. “Sometimes people start businesses with a dream of making money but don’t have the skill or interest to manage cash flow, taxes, expenses, and other financial issues. Poor accounting practice puts a business on a path straight to failure,” writes Mike Kamo in his book ‘Six Reasons Your Small Business Will Fail (And How to Avoid Them)’. Hence, if something is erroneous in the balance sheet of a company the whole business is put at a risk. Many are of the opinion that balance sheet is just an accounting and audit necessity. But the reason to give importance to analyzing a balance sheet is that it can inform us about the kinds and degrees of financial risk an organisation faces as it delivers on its missions. A balance sheet also reflects the attitude and dedication of a company’s management.

Healthy liquidity measures and strong balance sheet are good signs of a company. Investors must generally look at audited financial statements as the statements are independently assessed. It also provides for notes to the audit, which one should always review as it can provide helpful details that may not be evident in the balance sheet itself. Additionally, balance sheet can’t be the only document to base your decisions on. It always a good idea to have an income statement nearby as balance sheet is a snapshot in time. Also, it is advised to analyze balance sheets over multiple years. Reviewing balance sheets of previous three to five years enables us to understand a company’s financial structure and ongoing needs. For some, the shifts in their balance sheet composition are minimal over a several years’ period while for others there can be substantial growth or downsizing.