Balance sheet analysis at depth are often ignored but one of the most important part of fundamental analysis.
I have created following checklist for balance sheet analysis based on my experience of fundamental analysis of shares. Most important things that are important for investment point of view are covered here.
- Whether share capital is increasing year on year? If yes then what are the reasons for that?
There can be many reasons for that. Like raising capital for acquisition of businesses, mergers, exercising of Employee stock options, capacity expansion or raising capital to fund present business operations .
We will discuss about each of them here.
Mergers and Acquisition :
If share capital in Balance sheet increased due to this reason then investor must make short analysis of acquired or merged company. Most important thing is to check whether business is bought at overvalued price, will acquired business and present business will add value when combined because of backward or forward integration or any other possible reasons.
Compare Return on capital employed of both acquired are acquirer business.
Look if management is buying totally unrelated business just to gain artificial growth. As in real life it is very hard to manage totally unrelated business without adequate expertise and experience. It works very rarely.
Capacity Expansion :
Every penny of capital obtained by the company has a cost and that cost is opportunity cost. If present interest rate on risk free bonds are 8% and return on investment if expanded business is 7% then there is no logic to expand such kind of business.
So compare opportunity cost with return on investment .
Many things can be taken as capital cost like risk free bonds rate, cost of equity, cost of debt, etc.
Employees stock options plan
Employee stock options is the easiest way of getting high compensations without putting much strain on balance sheet. But this eventually cause dilution of shares so the return f previous investors get reduced.
Investor shall track is stock options are diluting shares each year to large extent. Anything near or above 1% percent is high.
Present business funding
Raising capital in to fund present operations is huge red flag. This means that company’s own profit is not sufficient for its costs. Continuous negative free cash flows is reason for this.
2. Does company have financial instrument like warrants convertible prefernece share that will increase equity share capital in future ?
If answer is yes then figure out what will be possible implications on shareholders of the company.
3. If company have preference share ,then what is date of their maturity, are there adequate reserves for their redemption? Is there any possibility of default in redemption or payment of preference dividend ?
Reserves And Surplus
- Understand each and every reserves created ?
2. Know purpose of each Reserves ?
3. Check if they are adequate of their purpose?
Reserves alone are not so important for investor but if combined with share capital then we get shareholders fund which is very important to derive certain ratios.
Shareholders fund is basically the amount which belongs to shareholders. This amount is converted to fixed assets on the other side of liability.
Thus this figure is used as denominator to find return to shareholders.
Return on Equity (ROE) is most important ratio to look for it shall be compared with other competitors of same industry.
ROE can be misleading if company have too much borrowing by company thus i recommend to use Du Pont model for return on equity.
Return on Incremental equity is also important ratio but not that widely used.
Long Term Borrowing
Debt is most important factor in balance sheet because this is element is cause of most of the business closures in the world.
Most emphasis is given to Debt to Equity Ratio but I think this is wrong. As we pay debt using our profits before interest and taxes. Only at the time of bankruptcy or dissolution of business assets(equity capital is forms assets on other side of balance sheet) are used to pay debt obligation.
And I think investor never value business considering Default in debt payment scenario because in such case it should not form part of possibly buy list.
Even if debt to equity ratio is 4:1 but companies have high revenue and EBIT growth with strong business fundamentals then debt is good for investors as it will increase Return on Equity.
If considered opposite scenario in which debt to equity ratio is 0.5 or 0.2. But company revenue is decreasing it will be difficult to pay obligations even thou debt to equity ratio is so attractive .
So more emphasis on EBIT(Earnings before interest and taxes.) than on amount of assets to pay debt.
- Interest is taken fixed rate or floating rate.
Floating rated debt has another risk which is interest rate risk. When rate of interest increases then interest expense of floating debt increases.
2. Interest coverage ratio.
Interest coverage ratio = Earnings before interest and taxes /Interest expense.
3. Debt Service Coverage Ratio
Only payment of interest is not sufficient company should be self sufficient to pay principal also which forms part of installment .
For measuring ability to pay installment there is debt service coverage ratio.
Debt Service coverage ratio = EBITDA – Capex/ Interest + principal
EBITDA – Earnings before interest taxes depreciation and amortization.
Capex – Capital Expenditure ( figure can be obtained from investment activities section of cash flow statement.
4. Compare collective interest rate and Return on investment(ROI) .
If interest rate are more than Return on investment then there is no point of having any debt on the balance sheet. 100% equity will be the ideal capital structure in this case.
If ROI has margin over interest rate but very thin then also it may not justifiable because interest bring other risks with if like default risk , interest rate fluctuation risk, etc.
Collective interest rate can be calculated by dividing interest expenses shown in the profit and loss statement by total debt (both long term and short term in nature) in balance sheet.
5. Year-on -year change in debt.
Change in debt levels shall not be compared on absolute basis but with the growth of overall business growth rate.
Also change can be measured as change in the interest coverage ratio.
6. Whether company is raising debt because profits are proving insufficient to fund internal growth and continuance if daily operations of business .
If yes, then it is red flag.
7. Free Cash Flow / Total Installment Ratio.
There is need to use this ratio because Profit and loss statement is very easy to manipulate. But cash flows cannot be manipulated.
If company have a cash free to their business then there should be no problem to paying installments. This ratio sole have little value but it can be very helpful when used with other above stated ratios .
Free Cash Flow/Total Obligations per year. If greater than 1.00 company will not face any major problem in payments of debt.
8. Compare all the points discussed above with other players in the industry.
9. Secured and unsecured loans
If company have lot of unsecured loans then this means that company have a string goodwill in market .
10. Whether there is debt given by directors or promoters in business , if yes then whether terms of debt are favorable to company .
Most of time directors fund company with debt to review company from troubles. But sometimes debt can given to gain unreasonable interest from company which harm earnings available to shareholders.
Also read : Mistakes 99% stock traders make in market.
Calculate Creditors turnover ratio and debtors turnover ratio and compare it with others players in the industry.
Academics consider less trade payable a good thing. But I think if company has other obligations like interest on loans controllable which can create strain on profits in bad times then high trade payables can be wonderful because it gives leverage without interest .
Other thing it shows bargaining power of company to its suppliers.
- Creditor Days.
- Creditor Turnover ratio.
Are some of the most important ratios where changes must be track year-on-year.
Here advances are taken in context of amount paid for buying product and services and not in the context of loans.
1.Whether all players in industry receive advances ?
If company is only player who receive advances then there is certain that company have huge competitive advantage. But if it is standard process of industry then advances are not receivable are not that great signals.
2. Calculate advance days.
Advance days can be calculated same as the creditor days .
Turnover divided by advances and then multiplied by number of days in a year gives advance days.
3. Compare advance days with competitors if all companies in an industry receive advances.
Short term loans
Interest rate of short term loans can be compared to other companies if anyone is getting way less rate than other then it indicates high credibility if that company.
Provisions are very fragile topic because provisions are formed at expense of profits. Amount of provisions to be formed is based on the management assessment of expected outflow of resources from an enterprise.
Management can underestimate requirement of provisions may be because of two reasons one if wrong estimations of risk in event and other is management does not want to put pressure on profit margins.
One should also take a look at contingent liabilities because there can be sudden change in the estimation can large amount of provision may needed to be formed for these liabilities.
This applies to the balance sheet analysis also. There are many things like deferred tax liabilities, deferred expenses, interest due but not accrued, etc. which are on the liability side of balance sheet but this things do not have that much impact on fundamental analysis.
There are so much element to keep track of in fundamental analysis that it is better to skip some unimportant things.