How do you buy a stock? Do you watch television news channels and then decide? Do you read newspapers and magazines and decide to a buy a stock? Do you use the tips of your broker or financial advisor to buy a stock? What about your own skills?
Most of the investors who buy shares are not to analyse the performance of a company as they feel that they do not have necessary skills to evaluate the performance of a company? Is it really challenging to understand the financial performance of a company? Is it something that only experts can understand? Do you need to be a Chartered Accountant, finance graduate degree to analyse a company?
The analysis of a company needs the common sense approach which requires very basic understanding of finance. The key document for understanding performance of a company is it's annual report. The annual report of a company is available in public domain. Even if you not a shareholder of a company, you can access the annual report. All the listed companies publish their annual reports on the website of their companies. You can download the soft copy of the report and use the same for the purpose of analysis.
Ideally should refer to annual report of a company for three to five years for understanding the performance. Many websites provide consolidated reports for last three to five years. Once you the report, please go through the statement of managing director/chairman of the company published in the report. Annual reports provide details of different segment in which a company operates. Please go through it as you will have fair idea about how the company has performed in different segments.
You need to refer to three statements published by the company for the purpose of analysis of a company:
1) Balance Sheet
2) Profit and Loss Account
3) Cash Flow Statement.
The scope of this article is confined to the balance sheet. The balance sheet of a company gives an idea about its assets and liabilities. Please note that assets are owned by the company and liabilities are something that the company owes to outsiders. So please note that equity capital is a liability for a company as it is owned by the company to its shareholders. Profit is also a liability though it may look like an asset to a layman. Profit is generated by the day to day operations of a company and it is owned by the shareholders. Similarly loans taken by a company is also liability. Typical example of assets is land, building, machinery, bank balance, investments. Assets and liabilities are classified as long and current. Current liabilities have duration less than a year, while long term liabilities have duration of more than a year.
Now, the question arises is what do you do with balance sheet. Balance sheet gives you an idea about how the company has grown over the years and how is the composition of its assets and liabilities. Look at the liabilities of the company and find if the reserves and surplus of a company have gone up over a period of time. Increase in reserves and surplus generally indicate two things: 1) The company may have generated continuous profits over the year which has inflated its reserves, 2) The company has raised some capital from the market which could have increased its reserves and surplus. In event of 2nd scenario, you will find that the equity capital of a company has increased as well.
Increase in reserves owing to profits is a good sign for the company. Another aspect of balance sheet interpretation is to look at current ratio of a company which gives an indication of how well equipped is a company to finance its current liabilities by current assets. A current ratio of more than one is good but in some cases, a company may get credit from its suppliers which may reduce current ratio to less than one. Take the example of a company like ,'Shoppers Stop'. It gets credit from its supplier in form of various articles like shirts, toys etc. This reduces the current ratio of the company. In this kind of scenario, less than one current ratio need not be viewed negatively.
Balance sheet also gives an idea about the investments made by the company. The investments done by the company becomes a source of revenue for a company and hence is viewed positively in most cases. The investments also give an idea that the company has surplus cash which has been used for investment.
Balance sheet also gives an idea about long term liabilities of the company. Equity, preference shares and debt are three long term liabilities that a company generally has. Please note that all these have cost for the company. While the cost of equity shares is dividend, the cost of debt is the interest payment that a company makes. For the preference shares, the company pays preference dividend. The company must ensure that the cost that it is paying to raise long term capital is recovered by the business it runs.
You also need to look at the intangibles in the balance sheet of a company. Intangibles are the non-physical assets owned by the company. Some of the examples of intangibles are goodwill, trademark, patent, brand etc. All these intangibles add value to the asset of a company. The significance of a brand can be learnt from the fact that when Coca- Cola entered Indian market, it purchased 'Thumbs Up' which was a famous Indian brand at that time. The Parle only sold the brand to Cola-Cola and earned a huge profit. This example shows the significance of intangibles in the balance sheet.
For detailed understanding, please refer a basic book on accounting.
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