How to identify a rich stock that is financially stable from others that are not?
The answer is to read and interpret a company’s statement of financial position which is commonly known as a balance sheet. It is a snapshot that tells us what and how much a company owns and owes in a single point of time. Personally, I would like to know whether or not, a company is financially capable to invest in its expansionary activities and thus, grow in the future.
For a start, let me share a sample of a company’s balance sheet:
Here, I’ll share 8 main things on a company’s balance sheet so that you are able to make sense of it. They are as follows:
#1: Reporting Date
From above, the reporting date stated is 31 December 2018. Hence, it reports a list of what and how much a company has and owes as at 31 December 2018. It also reports what and how much a company owns and owes one year ago. That is 31 December 2017 and it is used mainly for comparison.
#2: Why Report ‘Group’ and ‘Company’?
First, let me define what a company and a group is.
The above balance sheet belongs to Heineken Malaysia Bhd (HMB). HMB is one entity that owns the following subsidiaries:
HMB and its three companies above have their own individual sets of financials and thus, having their own balance sheets.
The balance sheet for a company refers to the individual set of balance sheet of HMB only. It excludes the balance sheets of its three companies.
Meanwhile, the balance sheet of a group refers to the collective reporting of all companies owned by HMB and hence, is inclusive.
Personally, I read the group’s balance sheet as it is more relevant to investors. It is because, if I invest in HMB, I would be making money from HMB and its three companies stated above.
#3: Assets = Equity + Liabilities
Statement of financial position is known as a balance sheet as the accounts had to be ‘balanced’ with the equation: Assets = Equity + Liabilities. This equation is then broken down with the table below:
On a personal level, you may have a balance sheet that looks like:
On a corporate level, its balance sheet (referring to HMB) consists of:
#4: Usage 1 – Can a Company Pays its Bills Comfortably?
First, I want to find out whether or not, a company (using HMB as a case study) is able to:
- Pay bills and fund its operations comfortably.
- Have excess financial resources to invest for expansion.
It involves a calculation of a stock’s current ratio where its formula is:
Current Ratio = Current Assets / Current Liabilities
Thus, HMB’s current ratio is 1.13 in 2018 and it is calculated as follows:
HMB’s Current Ratio (2018)
= Current Assets / Current Liabilities
= RM 604.199 million / RM 535.572 million
It indicates HMB has current assets that can finance 1.13 years worth of current liabilities. In brief, the higher a company’s current ratio, the greater its ability to invest for its future.
#5: Usage 2 – Is it Conservatively Financed?
I’m not against debt.
But, it is helpful to acknowledge that debt is a double-edged sword.
Good stocks use debt to get richer. Bad stocks fail to do so and became poorer.
Personally, I prefer to invest in stocks that have low debt-to-equity ratio (below 50%). Debt-to-equity ratio is calculated as follows:
Debt-to-Equity Ratio = (Total Interest-Bearing Debt / Total Equity) x 100%
From HMB’s liabilities, the only interest-bearing debt it has is revolving credits worth RM 75.0 million.
Thus, HMB’s debt-to-equity ratio is 41.44% in 2018 and is calculated as follows:
HMB’s Total Debt-to-Equity Ratio (2018)
= (Total Interest-bearing Debt / Total Equity) x 100%
= (RM 75.0 million / RM 180.997 million) x 100%
#6: Usage 3 – How Efficient a Stock is in Generating Profits to Shareholders?
Now, let’s move onto something more advanced.
For investors (or existing shareholders) of a stock, what we would be owning at a given point of time is the stock’s equity – Shareholders’ Equity. It is likened to the stock’s net worth.
The question is, ‘How efficient it is in using shareholders’ equity to make profits for us and how consistent is it?’
The answer is to calculate the stock’s Return on Equity (ROE) for the last five or ten years. The formula is as follows:
ROE = (Shareholders’ Earnings / Shareholders’ Equity) x 100%
Figures of a stock’s shareholders’ earnings are obtained in its income statement or statement of profit or loss.
HMB’s ROE for 2018 is
HMB’s ROE (2018)
= (Shareholders’ Earnings / Shareholders’ Equity) x 100%
= RM 282.520 million / RM 371.147 million) x 100%
It means, HMB had made RM 76.12 in profits in 2018 from every RM 100 it has in shareholders’ equity. In terms of consistency, HMB’s ROE figures for the past five years is as follows:
2016* refers to a period of 18 months from 1 July 2016 to 31 December 2017.
#7: Usage 4 – Cash Conversion Cycle
This deserves another write-up. Here, suffice to say, it measures the amount of working capital a stock needs to have to run its business operations in terms of time (days or months). The more days in working capital a stock needs, the less ability it has to deploy its cash or capital for investment or expansion purposes.
Balance sheet is a simple document that accounts for what it has and owes in a single period of time. What is more important is that we can use its information to identify stocks that are rich, financially stable, and efficient in using equity to generate consistent profits to shareholders.