Tuesday, August 21, 2007

Research Series Part 6 – The Balance Sheet

Part 6 of my research series focuses on the balance sheet of a company. For readers who are not familiar with accounting, the Balance Sheet is simply a statement of affairs of a company and consists of a summary of its assets, liabilities and equity. The formula is assets minus liabilities equals to equity, and any net profit or loss will be added to or deducted from equity respectively. This is how the Income Statement flows into the Balance Sheet. Another point to note is that the Income Statement represents the FLOW of revenues and expenses for the entire financial year, while the Balance Sheet reperesents a SNAPSHOT in time for the company (e.g. December 31, 2006). Thus, the balance sheet for January 1, 2007 may be very different from that of December 31, 2006.

In spite of this drawback of lacking the “flow” concept, a balance sheet analysis is absolutely essential in researching a company as it gives investors a summary of the types and amounts of assets and liabilities of a company, and how these can affect the operations and financial health of the company in future periods. Note that many items on the Balance Sheet have multiple period effects, meaning that their effects can linger for more than one financial period. This is in contrast to Income Statements where what you see may only pertain to one financial period (the one under review, that is). An example of a multiple period item would be a 5-year long-term loan, which has interest expenses accruing on a yearly basis for 5 financial periods.I will not go into an excessively lengthy and technical explanation of the Balance Sheet, as most readers are not accounting-trained and writing such a post will simply put everyone to sleep ! Instead, I will focus on salient parts of the Balance Sheet with the hope of simplifying key aspects such that laymen and normal investors can get a grip of a company’s financial standing. The items to be touched on are as follows:-

1) Fixed Assets – Companies which spend on fixed assets (called capital expenditures or capex) usually should have some form of justification for it. Some companies may be building new plants, acquiring more machinery to expand operations, or even buying up leasehold property in order to expand their premises. Such moves involve large amounts of cash to be paid and one must note that there is an Income Statement effect called depreciation for high capex companies. Most investors like to hear news of companies building new plants or acquiring new assets through subsidiaries but neglect to think of the effects of depreciation which will eat into the bottom line. For more information on depreciation methods and how to compute this, please consult any Annual Report’s section on accounting policies.

2) Intangible Assets – This would include goodwill, patents, trademarks and rights to original published material. These assets are so named as they do not have physical substance but constitutes a certain value nonetheless because of the premium that people place on having such assets. Note that goodwill is externally acquired and cannot be internally generated (nope, you do NOT generate goodwill by being friendly to your boss !) and this usually happens when the cost of acquisition exceeds the NTA value of an acquiree company. The excess will be booked as goodwill. Any increase should be investigated as it will lead to amortization charges which impact the income statement (amortization is similar to depreciation but accountants just like to call it something different).

3) Trade Receivables (Debtors) – The increase in debtors should be roughly equal to the increase in revenues (makes sense unless most of the revenues consist of cash sales !). If the increase (in % terms) is greater than the increase in revenues, one must look at the number of days of receivables outstanding to get a better idea of how fast their debtors pay up. Normally, a significant increase in receivables should be an area of concern as this may mean that while the company is generating higher revenues, they may not be generating cash inflows as quickly.

4) Inventories (Stocks) – For companies which are into manufacturing, retail or trading, this number is significant as it tells the reader how fast inventories are being used and the turnaround time for stocks to be sold. Check out the note to the accounts pertaining to the inventories to see how well the company is managing their inventory. Excessive build up of inventories may point towards an inability to sell due to obsolescence, which may prompt a stock write-off in future periods (this happens to some IT companies). Too little inventory is also not good as it may indicate that the company’s re-order procedure is flawed, thus leaving them out of stock and unable to generate revenues.

5) Cash and Bank Balances – This is probably the single most important item within the balance sheet and is the item hardly anybody talks about (in forums at least, everyone loves to concentrate on profit, sales and margins only). I will dedicate an entire posting on the cash flow statement in part 7 but for now, all I can say is that a company with good free-cash flow (FCF) from operating activities is fundamentally strong enough to withstand recessions and a high interest rate environment (assuming it is moderately geared).

6) Trade Payables (Creditors) – Kind of the opposite of debtors, this measures how fast creditors are being paid off and it is important for a discerning reader to ascertain the cash conversion cycle; which is the rate of stockturn plus the rate of receivables turn minus the rate of payables turn. The cash conversion days will give an idea of how fast the company can generate cash to fund its operations and whether they are paying creditors faster than they are collecting from debtors. One example is my recently reviewed Global Voice (read the review for more details).

7) Bank Loans – The amount of loans on a company’s balance sheet divided by its equity is called “gearing” or “leverage”. This represents the indebtedness of the company to banks and financial institutions, and can be an important barometer to compare against other companies within the same industry. If bank loans increased a lot, it may show that the company is relying on too much leverage to grow, which is unhealthy because of the high interest costs involved. However, on the flip side, some gearing is also good as it helps to finance the costs of capex and/or expansion in the short term when the company may be just starting out.

This is just a simple summary of the major items to look out for in the Balance Sheet. There are two ratios which are of particular importance with regards to the balance sheet, and they are the current ratio and the quick (acid-test) ratio. Current ratio is simply current assets divided by current liabilities and measures how much each dollar of liability is supported by current assets. If current liabilities exceed current assets, then the company is in negative working capital and is technically “insolvent” as it is unable to repay all its short-term liabilities. This is a dangerous situation for any company. The quick ratio is similar to the current ratio except that the numerator is “current assets less inventories”; and this is to measure the liquidity of the remaining current assets to service the curent liabilities. Many companies who have too much of their assets focused in inventories will show a low quick ratio. This may be an indication that inventories are stockpiling into unhealthy levels.

What an investor must do is to read the income statement in conjunction with the Balance Sheet, as both are linked to each other. Practice reading up on Balance Sheets and Income Statements of various local listed companies to give yourself a flavour of what you will be analyzing and how to go about doing it. Nothing beats practice, as they say !

Note: I will be starting a new series soon on “Personal Finance” which talks and discusses about good habits to build wealth, owning cars, property, credit and debit cards, loans and also money-saving habits. A little bit on taxes as well, if readers are interested. Please give me feedback on what you wish to know more about by commenting ! Thanks !

8 comments:

Anonymous said...

hi,

an excellent post once again. i've just finish reading the book on How to Think Like Ben Graham and Trade like Warren Buffett (or something like that), and the definitions of the ratios are in it.

my investment strategy is similar to yours. just that now, i feel that the credit crisis is too huge to ignore. thus, i may sell on strength even if they are good companies like Pac Andes (yes, i'm vested too!). no point fighting against the tide when it is obvious.

fyi, my average for Pac Andes is slight over 50c. holding since early 06.

harry

musicwhiz said...

Hi Harry,

Thanks for visiting my blog and glad to know we share similar views on investing. Yes, I think I have seen that book at the stores but have not had a chance to flip through it yet.

I agree that the credit crisis is a big sore issue and will not go away anytime soon. However, I don't see how it will affect the companies which I invest in unless they plan to increase their gearing. If borrowing is made more difficult and liquidity dries up, it simply means valuations will be less demanding and that good companies may be under-valued for quite some time. In such cases, I see the opportunity to collect more as I am not in a hurry to realize any cash; thus I adopt a long-term view of at least 5-10 years. While it is also true that shares can stay under-valued longer than you can stay solvent (I believe John Maynard Keynes said this), I do have a cash stash which can tide me over more than a few months should a recession come along.

I congratulate you on managing to accumulate PAH at such a low price ! I would think the regular dividends (twice yearly now) and the potential capital gains should make you hold on to this gem a little longer.

Good luck !

Cheers, musicwhiz

8percentpa said...

Most of the time, the markets will stay irrational longer than we can stay solvent.

The rest of the time, our emotions take over and make us sell to Mr Market when prices are at rock bottom.

Esp when you have held the stock and it kept going down until you decide to give up and cut loss. Then it bounces up!

musicwhiz said...

Yep, markets can stay irrational for long periods of time. This is why the margin of safety is so important. Holding power is also crucial for protracted periods of market slump which results from a recession or economic downturn. In such cases, I think collecting a steady stream of dividends from cash-rich companies as well as REITS sounds like a good proposition !

Anonymous said...

Hi, can you rate the financial strength from the balance sheet of PAD and whether the company can withstand prolong period, say 3 years, if China stock mkt crash and consumers tighten belts and eat less fish?

musicwhiz said...

Hi Anonymous,

From my balance sheet analysis, apparently PAH Management knows how to properly manage their balance sheet as of this moment. I can't tell for sure 3 years later as the world would be a very different place by then. All I can say is that we should monitor the results for PAH and see if the Balance Sheet is being prudently managed. All 3 financial statements should be read concurrently in order to assess the health of the business.

Cheers, musicwhiz

Anonymous said...

Hi Musicwhiz,

Thank you for your response re: China Fishery or Pac Andes in SJ. Decided that I will respond here to let you know that I enjoy reading your excellent posts in your own blog. It was not a test qn but a genuine one as I have noW some more fund. I could not decide to vest in CFish or PAD (already vested w 90c avg cost). Thanks for your advice.

Easton

musicwhiz said...

Hi Easton,

You are most welcome.

Thanks too for regularly visiting my blog.

Have a great weekend ! :)