The Beginner’s Guide to Analysing Financial Statements - Balance Sheet

by: Tam Ging Wien

When read with begin with A...B...C..., when we sing with begin with Do... Re...Me...

That at least that's how the song lyrics go.

But when we want to understand and assess the financials of a stock, we need to begin with the 3 financial statements, namely:

In our last "The Beginner’s Guide to..." series, we covered the The Beginner’s Guide to Understanding The 3 Financial Statements.

After having an understand of the 3 financial statements, we continue the series with analysing these financial statements in order to understand the financial health of a company. In this post, we will be learning how to analyse the Balance Sheet.

Do read the previous article first before continuing as it will give you a firm foundation of the 3 core financial statements.

Balance Sheet

Current Ratio

This is a simple ratio of the current assets over the current liabilities. Current liabilities are liabilities that need to be cleared in the short term, typically less than one year. Therefore, it is essential to ensure sufficient liquidity to fulfil these short term obligations in order to stay afloat or else the company may run the risk of falling into insolvency.

In general, if a company has a current ratio of less than one, it runs a risk of falling into insolvency. A wise investor would want to avoid such a risky investment. A company with a current ratio of above 1 is essential and a current ratio above 2 is desirable for an investment grade company.

Quick Ratio

Quick ratio is similar to the current ratio except that it conservatively assumes that if none of the inventories or stocks are sold, then the company can still continue to fulfill these short term obligation.

In general, if a company has a quick ratio of less than 0.75, it runs a risk of falling into insolvency. A wise investor would want to avoid such a risky investment. A company with a quick ratio of above 0.75 is necessary and a quick ratio above 1.25 is desirable as an investment grade company.

Cash Ratio

The cash ratio measures the ratio between the cash to the current liabilities. Assuming that no other cash is received in the short term, this ratio gives an indication of how long the current cash reserves of the company are able to keep the company afloat before hitting or falling into insolvency. A cash ratio of 1 indicates that the company is able to continue to fulfil its short term debt obligations for 1 year, assuming no additional cash is received throughout the year.

While there is no general rule on what a recommended cash ratio should be, obviously the higher this ratio, the better the financial situation of the company. We would recommend ensuring that your investments conservatively have a cash ratio of approximately 1 or higher.

Debt Ratio (Gearing or Debt-to-Asset Ratio)

This is a simple ratio of the total liabilities over the total assets, also known as the gearing. This is an important ratio as it gives an indication of how much debt a company has taken on. Another way to look at the debt ratio is the amount of the company’s assets which are financed using debt. Generally speaking, the lower the debt of a company, the better it’s financial health. Debt if used wisely, can help boost the business, however, take on too much debt and the company may spiral down a vicious cycle of continuously borrowing new debt to repay old debt ending up in bankruptcy.

In general, if a company has a debt ratio of more than 1.0, it may be taking on too much debt for its own good. A wise investor would want to avoid such a risky investment. A company with a debt ratio of below 0.75 is necessary and a debt ratio below 0.5 is desirable as an investment grade company.

Debt-to-Equity Ratio

Similar to the debt ratio, the debt-to-equity ratio provides an indication of how much debt a company has taken up relative to its equity. It can be calculated by taking the ratio of the total liabilities over the total equity. Since the equity is the amount owed to the shareholders, one can look at the debt-to-equity ratio to gauge how much risk the company has taken up against the shareholders’ value.

In general, if a company has a debt-to-equity ratio of more than 1.5, it may be taking on too much debt for it's own good. A wise investor would want to avoid such a risky investment. A company with a debt ratio of below 1.0 is essential and a debt ratio below 0.75 is desirable as an investment grade company.

Net Asset Value per Share (NAV per Share)

The net asset value or as it is sometimes known, the book value, is the total amount left over after all assets are sold at the value stated on the financial statements and used to pay off all liabilities. The Net Asset Value can be compared to on a per share basis against the trading price of a share. 

 By comparing the NAV per Share to the traded share price, we can ascertain how cheap or how expensive the current stock price is relative to its asset value.

This method of assessment is known as assessing the price-to-book ratio and is ideal for companies that have large amounts of assets such as banks, REITs and property developers.

Generally speaking if an asset heavy company has a price-to-book ratio less than 1, then it is it considered undervalued. On the other hand, if the price-to-book ratio is greater than 1, then it is considered overvalued. If possible, an investor should invest only when the price of the stock is trading at a price-to-book ratio below 1.

We hope you have enjoyed this educational piece from ProButterflyTM!

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