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Lesson 1: The Balance Sheet

balance sheet, fundamental analysis

balance sheet, fundamental analysisWith this article, begins a series of articles on the fundamental analysis to provide the means to evaluate a company from the point of view: the balance sheet, the income statement and the cash flow statement.

 

 

Premise

Even though this argument is of great interest on the part of traders and investors, and despite the importance of it is confirmed by the excellent results in their investments, by those who managed to master the matter, it is apparently impossible to deal in a way wholly exhaustive and complete this argument with some article.

Although you have not to deceive yourselves that you can become experienced analysts with the reading of some articles, you have not, however, to diminish the importance of addressing this argument even though in a few lines. Curiosity, interest, and passion that could arise from a few lines of an article could do miracles if followed by a more in-depth and constant study.

Exhausted this dutiful premise, we begin to understand why it is essential to analyse from a balance, income and financial point of view a company in which we want to invest. The three analyses, we face are derived from the budget data that listed or not companies provide periodically. In this article, we start to see the Balance sheet.

 

Balance Sheet

The balance sheet highlights the financial condition of a company, and it reports the company's assets, liabilities, and equity on a given day. The balance sheet can be defined as a snapshot of a company's health.

Differently, from the income statement, the balance sheet does not report activities over a period. The balance sheet is essentially a picture of a company's recourses, debts, and ownership on a given day. This is why the balance sheet is sometimes considered less reliable or less telling of a company's current financial performance than a profit and loss statement.

The balance sheet shows how the resources controlled by the business (assets) are financed by debt (liabilities) or shareholder investments (equity). Investors and creditors look at the statement of financial position for insight as to how efficiently a company can use its resources and how adequately it can finance them.

The balance sheet can be reported in two different formats: account form and report form. The account form consists of two columns displaying assets in the left column of the report and liabilities and equity on the right one. The report form, instead, contains the same entries, but on only one column.

 

Assets

The asset section is organised in current assets and non-current assets. In current assets there are several items found on the balance sheet, the most important are three: cash, inventories and accounts receivables.

Cash. Investors usually look kindly on companies with a lot of cash on their balance sheets. It is an “insurance” against tough times, and it also gives to companies more opportunities to grow. However, if cash is more or less a permanent feature of the company's balance sheet a reason could be because management has run out of investment opportunities.

Inventories, or closing stocks, are finished products that have not yet been sold. Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the company is moving goods from the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deterioration of the fundamentals.

Account receivables. Analysing the speed with which a company collects what is due, can tell us a lot about its financial efficiency. If the collection period of a company is growing longer, it could mean problems in sight. The company may allow customers to extend their credit, but in future, this could cause problems, especially if customers are faced with a financial crisis. Making money right now is better than waiting for it because some of what is owed can never be paid.

In non-current assets, there are assets that are not likely to turn to unrestricted cash within one year of the balance sheet date, such as property, plant, equipment, trademarks, certain investments in other corporations. Unless the company is in financial difficulty and short of liquidity, investors need not pay much attention to fixed assets.

 

Liabilities

As for assets, there are current liabilities and non-current liabilities. Current liabilities are the obligations that the company has to pay within a year, such as payments due to suppliers. Non-current liabilities, on the other hand, represent what the company has to pay over a period of not less than one year. Typically, non-current liabilities represent banks and bond debt.

If a company has more assets than liabilities, it means it is in decent conditions. A company, on the contrary, with plenty of liabilities than assets should be examined at with more significant attention. Having too much debt by reference to the cash flows needed to pay interest and repaying the debt is a possible viaticum towards bankruptcy.

 

Equity

Equity, in layman's terms, is what shareholders own (also called shareholder's equity). The two important equity items are paid-in capital and retained earnings.

Paid-in capital is the amount of money that shareholders had paid for their shares when the stock was first offered to the public. Simply it represents how much money the company had received when it sold its shares. Retained earnings are a part of the money the company has chosen to reinvest in the business rather than pay to shareholders. Investors have to look carefully at how a company uses its earnings.

Most of the information about debt can be found on the balance sheet. However, some assets and debt are not disclosed there. Even because companies often possess hard-to-measure intangible assets such as patents, trademarks, copyrights etc.

Furthermore, there is also off-balance sheet debt. Through particular classification methods, large capital expenditures are kept off of a company's balance sheet. In this way, the company can keep lowering its debt.

Below, you can see a sample Balance Sheet (click to enlarge).

 
balance sheet, fundamental analysis

In the next article, we will see the Income Statement.

 

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