How to do Balance Sheet Analysis: Using Shareholders Equity/Net Worth
One of the most important financial indicator detailed in the Balance Sheet is shareholders equity. This is also better known as Net Worth of a company. In doing a balance sheet analysis plays a important role. Net worth of a company is equal to total capital generated by the company by issuing stocks and accumulated retained earnings. A continuously improving net worth is what investors likes to see in companies balance sheet. Compare last five years net worth of a company and check if it has grown and at what rate. It is important to check how the net worth of company has grown? If increase in net worth is attributable only to the issuance of more stocks to public, then it is not good. Ideally, if the companies net worth has increase it should be directly attributable to the increase in retained earnings. While balance sheet analysis is done, special care must be taken to check if net worth has increased. And what factor has contributed to its increase/decrease.
How to do Balance Sheet Analysis: Using Cash Reserves
Fundamental investors first sees the cash reserves of a company while doing balance sheet analysis. A company which displays lots of cash is surely a more secured company. I must admit that no company would like to keep lot of spare cash. Instead of keeping cash they will prefer to make investments. So for sure predominantly excess cash is not good at all. But if we see a slow and steady increase in cash reserves of a company over a period of time, it means company is doing well. Trained investors while doing balance sheet analysis are often impressed with steadily increasing cash reserves.
How to do Balance Sheet Analysis: Using Working Capital
A healthy and improving working capital is a sign of a prospective company. While doing balance sheet analysis scrutinizing working capital will give a important clue. A company which has good working capital works very freely in the market. You can find working capital by subtracting current liability from current assets. The higher the working capital the better positioned is the company to manage its current liability. Improving working capital shows that the company has enough liquid cash to pay immediate bills. If the company is carrying
too much debt then working capital may go down. In order for a company to grow in long term, they must show continuously improving working capital. This is a very good health indicator about a business. A company can survive only if they maintain positive working capital. Even if they are making loss overall, working capital will make them survive.
How to do Balance Sheet Analysis: Using Financial leverage
While doing balance sheet analysis investors must check the financial leverage of a company. Financial Leverage of a company allows investors to compare two companies on basis of their debts. A company that has higher debts will be less favorable. In order to do balance sheet analysis of company to evaluate leverage we must first bring them in same level platform. Financial leverage is a tool that allows us to compare apple with apple. Financial leverage is the ratio of companies long term debt and net worth. Means we are comparing debt levels of a company in comparison of its net worth. It means a company which has higher net worth is allowed to have higher debts. It must be noted that debts are not always bad. Some profitable companies avail to cheaper debts from banks and generate profits. But of course too much debt is not good. In times of crisis (like liquidation) companies cash will be spent to pay back the debts. The balance left for shareholders after paying back 100% liability will be lot lesser.
Balance sheet analysis gives us another important valuation tool called debt/asset ratio. The level of debt can also be compared by using a ratio called as debt/asset ratio. This tool also allows investors to compare apple to apple. But it is important to understand that what debt/asset ratio tells about the company. Most of the companies’ assets (like inventories, account receivables, money market linked investments, cash) are financed by availing debts or equity. If debt/asset ratio is more than one means that they are under excess leverage. Excess leverage is a bad sign for a company and while doing balance sheet investors must take extra care to check debt/asset ratio. If this ratio is less than one (1) it means most of the companies’ assets are financed by equity which is the ideal way of operating a business.