- A balance sheet provides information on a company's assets and liabilities.
- Liabilities are obligations the company has to outside parties in the form of loans and debts.
- Understand the important balance sheet ratios to make informed investment decisions.
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We, at Amigobulls have always aimed to help you be a better investor. In our efforts to help you we shall today continue our series from yesterday aimed at helping you read a company’s financial statements better. Today we shall focus on the liabilities section and potential red flags in this section.
The liabilities are classified into three sub-sections namely current liabilities, Non-current liabilities and shareholder’s equity. The components under each of these heads are as follows:
Current liabilities consist of:
- Accounts & Notes payable
- Current portion of long term debt/capital leases
- Income taxes payable
- Other current liabilities
The non-current liabilities consist of:
- Deferred Charges/Taxes Income
- Convertible & Long term Debt
- Other long term liabilities
To arrive at shareholder’s equity we need to add up:
- Preferred Stock
- Common Stock Net
- Capital Surplus
- Retained Earnings
- Treasury Stock
From the above sum we need to subtract accumulated losses to arrive at final shareholders equity number.
We shall now look at the various parts of a balance sheet where management can be creative and which are potential red flags for an investor.
(For example: Look at the latest balance sheet for Apple)
Revenues in advance
A number of times companies may receive a significant order which has been pre-booked and the cash is already received for future work/goods. These revenues in advance can be a positive or a negative, depending on the time period over which the work is to be carried out. If the work is to be carried out within a short period of time (one year), the possibility of cost structure remaining constant is higher, thereby revenues in advance is a good thing for the company. However, If the work related to such revenue is spread over a long period of time, any significant changes in cost of production may result in a loss in the future. Therefore in case of any pre-booked revenues it is advisable for an investor to look into the time horizon over which such revenue will be recognized and the cost of such projects and compare the same with the company’s cash flow from operations. A significant cash flow margin to cover for unexpected losses from unrecognized revenues is a must for any investor.
Off balance sheet liabilities
Off balance sheet financing is a common phenomenon, but is rarely understood by common investors. Also the rules governing off balance sheet financing and its reporting are still in the grey, though authorities have worked over the years to tighten the rules to report them. Off balance sheet transactions can be a scary thing for investors as it picks liabilities from a company’s balance sheet and chucks the same out of a balance sheet.
The most common forms of off balance sheet financing used by companies are operating leases, sale and lease back agreements and partnerships. Under operating leases and sale and lease back agreements, companies can avoid recording the entire liability (used to finance a purchase) and report the lease rental as an operating expense in the income statement. In case of any lease agreements, the investor must read through the notes on leases and compare the lease rental values to the company’s cash flow. An investor must add the current value of all future lease rentals and, after considering the interest portion, treat the same as a debt to correctly understand the current leverage of the company.
Another famous off balance sheet financing method is the use of partnerships or special purpose entities (SPE). All investors from the Enron era will hate this word more than anything else as Enron was an empire built on partnerships which transferred liabilities to partnership firms resulting in a cleaner balance sheet for Enron. However all the liabilities were transferred to the SPEs which did not have to report anything to stock-exchanges.
Another red flag for an investor will be the contingent liabilities which may arise in the future. Contingent liabilities are obligations of the company, which will come into force on the occurrence of a specific event in the future. The contingent liabilities can result due to losing a lawsuits or guarantees given by the company which have become enforceable. An investor needs to read up the SEC filings of the company in order to correctly understand the quantum and significance of the contingent liabilities which may arise in the future. These liabilities do not appear on the balance sheet as they become liabilities only on occurrence of a trigger event.
Lastly an investor will be able to make better informed decisions if she does a ratio analysis of the important ratios in the balance sheet.
The important ratios in a balance sheet are:
- Debt to equity ratio (D/E ratio): The debt to equity ratio is the most common leverage ratio and tells the degree of financial leverage employed in a firm’s capital structure. It compares the current interest bearing debt with the current value of shareholders equity.
- Debt to total assets ratio: This ratio is also known as the leverage ratio and it tells what portion of total assets of a company is financed by debt. The ratio is derived by dividing the total debt by the value of total assets of the company.
- Current ratio: The current ratio compares the current assets against the current liabilities of a company. It is an important indicator of the company’s ability to pay off its obligations which will arise in the next one year. A higher current ratio is desirable while a lower ratio is considered risky.
- Quick ratio: Quick ratio compares the company’s current cash and cash equivalents balance against the current liabilities of the business. It is derived by dividing the cash and cash equivalents by the current liabilities of the firm and indicates the company’s ability to immediately pay off its current liabilities.
An investor will have to compare the important ratios of this period against the prior period numbers. Any significant change in these is to be investigated as it could have significant implications on the investors.
In conclusion reading the balance sheet in isolation will never be sufficient to make well informed decisions as an investor. The well informed investor must make it a practice to read the financial statements in tandem with the footnotes to get a complete overview of a company’s financial and operating position.
To see Apple’s latest stock price movement, click here Apple (AAPL)