Balance Sheet Basics

Balance Sheet is the snap shot of financial strength of any company at any point of time. It gives the details of the assets and the liabilities of the company. Understanding balance sheet is very important because it gives an idea of the financial strength of the company at any given point of time. Following is the balance sheet of Global Telesystems for the year ending on 3 st !ar" #$$$% &s on Assets Gross Bloc( -et Bloc( .apital /I0 Investments Inventory 3eceivables 4ther .urrent &ssets Balance Sheet Total 5iabilities 67uity Share .apital 3eserves Total 8ebt .reditors and &cceptances 4ther current liab9prov. Balance Sheet Total 232. # ,+ ,.1, #$)1.1) 3)3.) 2$#.,, ) 2#.)# 3)*+.,, #*)$.,* 11.*# 2,2.33 1 $.+ ,21.+ 31*3.1* ) 2#.)#

3 '3'$$

5et us ta(e a loo( at each of its components.

Assets

is the sum total of all assets of the company valued at their cost of ac7uisition. This is inclusive of the depreciation that is to be charged on each asset. Net block is the gross bloc( less accumulated depreciation on assets. -et bloc( is actually what the asset are worth to the company.
Gross block Capital work in progress:

sometimes at the end of the financial year: there is some construction or installation going on in the company: which is not complete: such installation is recorded in the boo(s as capital wor( in progress because it is asset for the business.

If the company has made some investments out of its free cash: it is recorded under the head investments. Inventory is the stoc( of goods that a company has at any point of time. Receivables include the debtors of the company: i.e.: it includes all those accounts which are to give money bac( to the company. Other current assets include all the assets: which can be converted into cash within a very short period of time li(e cash in ban( etc. is the owner"s e7uity. It is the most permanent source of finance for the company. Reserves include the free reserves of the company which are built out of the genuine profits of the company. Together they are (nown as net worth of the company.
Equity Share capital otal !ebt includes the long term and the short debt of the company. 5ong term is for a longer duration: usually for a period more than 3 years li(e debentures. Short term debt is for a lesser duration: usually for less than a year li(e ban( finance for wor(ing capital.

are those entities to which the company owes money. Other liabilities an! include all the liabilities that do not fall under any of the above heads and various provisions made.
Cre!itors provisions

Role of Balance Sheet in Investment Decision making &fter analy;ing the income statement: move on to the balance sheet and continue your analysis. /hile the income statement recaps three months" worth of operations: the balance sheet is a snapshot of what the company"s finances loo( li(e only on the last day of the 7uarter. <It"s much li(e if you too( every statement you received from every financial institution you have dealings with = ban(s: bro(erages: credit card issuers: mortgage ban(s: etc. = and listed the closing balances of each account.> /hen reviewing the balance sheet: (eep an eye on inventories and accounts receivable. If inventories are growing too 7uic(ly: perhaps some of it is outdated or obsolete. If the accounts receivable are growing faster than sales: then it might indicate a problem: such as la? credit policies or poor internal controls. Finally: ta(e a loo( at the liability side of the balance sheet. 5oo( at both long'term and short'term debt. @ave they increasedA If so: whyA @ow about accounts payableA &fter you"ve done the numerical analysis: read the comments made by management. They should have addressed anything that loo(ed unusual: such as a large increase in inventory. !anagement will also usually ma(e some statements about the future prospects of business. These comments are only the opinion of management: so use them as such. /hen all is said and done: you"ll probably have some new thoughts and ideas on your investments. By all means: write them down. Use your new benchmar( as a basis for analy;ing your portfolio ne?t time. Spending a few minutes li(e this each 7uarter reviewing your holdings can help you stay on trac( with your investment goals.
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Company Valuation
/henever people tal( about e7uity investments: one must have come across the word CDaluationC. In financial parlance: Daluation means how much a company is worth of. Tal(ing about e7uity investments: one should have an understanding of valuation. Daluation means the intrinsic worth of the company. There are various methods through which one can measure the intrinsic worth of a company. This section is aimed at providing a basic understanding of these methods of valuation. They are mentioned below% Net Asset Value (NAV) -&D or Boo( value is one of the most commonly used methods of valuation. &s the name suggests: it is the net value of all the assets of the company. If you divide it by the number of outstanding shares: you get the -&D per share. 4ne way to calculate -&D is to divide the net worth of the company by the total number of oooutstanding shares. Say: a companyEs share capital is 3s. $$ crores < $ crores shares of 3s. $ each> and its reserves and surplus is another 3s. $$ crores. -et worth of the company would be 3s. #$$ crores <e7uity and reserves> and -&D would be 3s. #$ per share <3s. #$$ crores divided by $ crores outstanding shares>. -&D can also be calculated by adding all the assets and subtracting all the outside liabilities from them. This will again boil down to net worth only. 4ne can use any of the two methods to find out -&D. 4ne can compare the -&D with the going mar(et price while ta(ing investment decisions. Discounted Cash lo!s "ethod (DC ) 8.F is the most widely used techni7ue to value a company. It ta(es into consideration the cash flows arising to the company and also the time value of money. ThatEs why: it is so popular. /hat actually happens in this is: the cash flows are calculated for a particular period of time <the time period is fi?ed ta(ing into consideration various factors>. These cash flows are discounted to the present at the cost of capital of the company. These discounted cash flows are then divided by the total number of outstanding shares to get the intrinsic worth per share.

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Value Analysis

#hat is undamental Analysis$ Fundamental analysis is the analysis: wherein the investment decisions are ta(en on the basis of the financial strength of the company. There are two approaches to fundamental analysis: vi;.: 6'I'. analysis or the Top 8own approach to Fundamental analysis and .'I'6 analysis or the Bottom up approach. In the following section: we e?plain both these approaches. %conomy&Indust'y&Company Analysis In the Top down approach: first of all the overall 6conomy is analy;ed to Fudge the general direction: in which the economy is heading. The direction in which the economy is heading has a bearing on the performance of various industries. Thats why 6conomy analysis is important. The output of the 6conomy analysis is a list of industries: which should perform well: given the general trend of the economy and also an idea: whether to invest or not in the given economic conditions. "easu'ing a Company(s inancial )ealth Gaining a true picture of a company"s finances means not only scrutini;ing the financial statements but also analy;ing relationships among various assets and liabilities: thus highlighting trends in a company"s performance and changes in its financial strength relative to its competitors. This section e?plains how to read a company"s financial statements. !easures of value % Book value is based on historical costs: not current values: but can provide an important measure of the relative value of a company over time. Boo( value can be figured as assets minus liabilities: or assets minus liabilities and intangible items such as goodwillG either way: the figure that results is the company"s net boo( value. This is contrasted with its mar(et capitali;ation: or total share price value: which is calculated by multiplying the outstanding shares by their current mar(et price. Hou can also compare a company"s ma'ket value to its *ook value on a per'share basis. 8ivide boo( value by the number of shares outstanding to get boo( value per share and compare the result to the current stoc( price to help determine if the company"s stoc( is fairly valued. !ost stoc(s trade above boo( value because investors believe that the company will grow and the value of its shares will: too. /hen boo( value per share is higher than the current share price: a company"s stoc( may be undervalued and a bargain to investors. In fact: the company itself may be a bargain: and hence a ta(eover target. +'ice,ea'nings 'atio (+,%) is the more common yardstic( of a company"s value. It is the current stoc( price divided by the earnings per share for the past year. For e?ample: a stoc( selling for I#$ with earnings of I# per share has a 096 of $. /hile there"s no set rule as to what"s a good 096: a low 096 is generally considered good because it may mean that the stoc( price has not risen to reflect its earning power. & high 096: on the other hand: may reflect an overpriced stoc( or decreasing earnings. &s with all of these ratios: however: it"s important to compare a company"s ratio to the ratios of other companies in the same industry.

A measu'e of solvency De*t&to&e-uity 'atio provides a measure of a company"s debt level. It is calculated by dividing total liabilities by shareholders" e7uity. & ratio of 'to'# or lower indicates that a company has relatively little debt. 3atios vary: however: depending on a company"s si;e and its industry: so compare a company"s financial ratios with those of its industry peers before drawing conclusions. "easu'es of li-uidity Cu''ent 'atio. .urrent assets divided by current liabilities yields the current ratio: a measure of a company"s li7uidity: or its ability to meet current debts. The higher the ratio: the greater the li7uidity. &s a rule of thumb: a healthy company"s current ratio is #'to' or greater.

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C'acking Ratios
Ratio Analysis 3atio &nalysis is the most commonly used analysis to Fudge the financial strength of a company. & lot of entities li(e research houses: investment ban(ers: financial institutions and investors ma(e use of this analysis to Fudge the financial strength of any company. This analysis ma(es use of certain ratios to achieve the above'mentioned purpose. There are certain benchmar(s fi?ed for each ratio and the actual ones are compared with these benchmar(s to Fudge as to how sound the company is. The ratios are divided into various categories: which are mentioned below% +'ofita*ility 'atios 0rofitability ratios spea( about the profitability of the company. The various profitability ratios used in the analysis are: operating margin <operating profit divided by net sales>: gross margin <gross profit divided by net sales> net profit margin <net profit divided by net sales>: return on e7uity <net profit divided by net worth of the company> and return on investment <operating profit divided by total assets>. &s obvious from the name: the higher these ratios the better for the company. Solvency 'atios These ratios are used to Fudge the long'term solvency of a firm. The most commonly used ratios are J 8ebt 67uity ratio <total debt divided by total e7uity>: 5ong term debt to e7uity ratio <long term debt divided by e7uity>. /hile the accepted norm for debt e7uity ratio differs from industry to industry: the usual accepted norm for 896 is

#% . It should not be more than this. For certain industries: a higher 896 is accepted: e.g.: in ban(ing industry: a debt e7uity ratio of #% is acceptable. .i-uidity 'atios These ratios are used to Fudge the short'term solvency of a firm. These ratios give an indication as to how li7uid a firm is. The most commonly used ratios are J .urrent ratio <all current assets divided by current liabilities> and 7uic( ratio <current assets e?cept inventory divided by current liabilities>. The accepted norm for current ratio is .,% . It should not be less than this. /u'nove' 'atios These ratios give an indication as to how efficiently a company is utili;ing its assets. The most commonly ratios are sales turnover ratio: inventory turnover ratio <average inventory divided by net sales> and asset turnover ratio <net sales divided by total assets>. The higher these ratios: the better for the company. Valuation Ratios Daluation ratios give an indication as to whether the stoc( is underpriced or overpriced at any point of time. The most commonly used ratios are 0rice to 6arnings <096> ratio and price to boo( value <0BD> ratio. But care has to be ta(en while interpreting these ratios. /hile 096 ratio of a company should be compared with the industry 096 and the 096 of the competitors: it is the 0BD that can distort. /hile a lower 0BD usually means a lower valuation: there can be a case where a low 0BD can be because of a very huge capital base of the company. In such a case: the stoc( might be overvalued but the 0BD will indicate that the stoc( is undervalued. 4n the other e?treme: a higher 0BD usually means overvalued stoc( but that can also be because the company has a very small capital base. So care has to ta(en while interpreting these ratios. Cove'age 'atios These ratios give an indication about the repayment capabilities of a company. The most commonly used coverage ratios are Interest coverage ratio <Interest outstanding divided by earnings before interest and ta?es> and debt service coverage ratio <earnings before interest and ta?es plus all non cash charges divided by interest outstanding plus the term loan repayment installment>. The acceptable norm for 8S.3 is #% .
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+'ofit .oss undas

Income statement is the snapshot of a company"s operational performance for a particular period of time. It ta(es the company"s revenues and e?penses and gives profits as output. Ta(e a loo( at the income statement of Global Telesystems% &s on -et Sales 4perating Income 4perating 0rofit 4perating 0B8T 4perating 0rofit before Ta?<0BT> -on'4perating Income 6?traordinary90rior 0eriod income Ta? 0rofit after ta?<0&T> .ash 0rofit 8ividend'67uity

3 '3'$$ 1$1,., 1#1,.13 # 1.,* *$$.22 )#+.13 ,1#.1# ' * .#3 3$.$$ ##)$.$# 3$1 .+# $$.2$

5et us ta(e a loo( at the different components of a Income statement of Global Tele.
First item is -et sales. -et sales is simply the product of 7uantity sold by the company and the selling price per unit. This figure is net of e?cise duty to be paid on the goods sold. -e?t comes operating e?penses. These are the e?penses incurred in producing the goods li(e labor: fuel: power etc. The difference between the net sales and the operating e?penses is the operating profit: which is a commonly used statistic to Fudge the operational performance of the company. -e?t comes 4perating profit before Ta?: which is nothing but operating profit less interest and depreciation. -on operating income is the income that is not earned in the normal course of business operations. For e?ample: interest earned on any investments made etc. 6?tra ordinary income is non recurring income that is earned only once and there are not any chances of earning that income again li(e profit on sale of any asset etc. .ash profit is 0&T plus any all non cash charges: i.e.: charges that don"t entail actual cash outflow but they are only notional charges li(e depreciation: writing off preliminary e?penses etc. Role of %a'nings in Investment decisions

4nce you have got an understanding of Income statement: you are ready to be your own analyst. 6ach 7uarter: companies release their earnings: and: for companies using the traditional calendar'year approach: the 7uarter ended on -ew Hear"s 6ve. 6arnings season is a great time to re'evaluate your current holdings to ma(e sure the companies you own are living up to your e?pectations. But before earnings are even announced: you might want to review why you made the investment in the first place. /henever you buy a stoc(: write down in three or four sentences why you are doing so. State your reasons as obFectively as you can. Hou might want to list such items as revenue growth: sustainability of earnings or growth over time: increased mar(et share: increased gross margins: price targets for the stoc( or any other reasons you

have for ma(ing the investment. For e?ample: you might write: CI am buying KHL .orp. because I thin( earnings will grow at a rate of #$M per year and that the price9earnings multiple will increase from its current level of 1 to between ## and #,.C By writing down your assumptions and your goals: you"ll create a benchmar( that can help you see over time how the company is performing. If you"ve never done this in the past: you might want to start now. -ow ta(e a loo( at the earnings. The earnings per share <60S> number is a good place to start. The 60S is the total net profit of the company divided by the number of shares of stoc( outstanding. But don"t Fust loo( at the actual 60S and compare it to the e?pected 60S. 0ull out your calculator and crunch some numbers. First of all: has the number of shares outstanding changed significantlyA @as the company bought bac( a large chun( of its stoc(A If so: earnings may have improved on a per'share basis: but may have stayed flat or even declined in real terms. -e?t: you should be on the loo(out for any one'time charges. Hou will want to remove the effect of the one'time charge: as it only creates noise and ma(es year'over'year comparisons more difficult. &ny one'time charge or gain will be stated in per'share amounts as a footnote. Nust subtract it from the 60S if it is a gain: or add it bac( if it is a loss. 4nce you have the 60S number e?clusive of one'time items: you can compare it to the 60S from the same 7uarter last year to see how much growth has occurred. .ompare the growth figure of your company to others in the same industry. 4nce you have gotten a good feel for the 60S: it"s time to loo( at the actual numbers on the income statement. @ere are some 7uestions to ponder while you have your calculator in hand. /hat does the growth rate in sales loo( li(eA @ow was it last 7uarterA &re gross margin percentages better or worse than they have been historicallyA &re e?penses increasing faster than salesA Using your written benchmar(s for the stoc(: create a couple of additional 7uestions to help you compare the company"s results with your own stated assumptions.

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Cash lo! Cu''ies

Thin( of cash as the lifeblood of every business. /ithout cash flow: no business can function and without an accurate picture of cash flow: no investor can have a complete picture of a company. & company"s statement of cash flows reflects how readily the business can pay its bills: and it provides important information about a company"s sources and uses of cash. But measuring cash flow solely from a balance sheet or an income statement is difficult and potentially misleading. That"s because not all revenue is received when a

company earns it: and not all e?penses are paid when incurred. <For an e?planation of financial statements: see C/hat"s the 8eal /ith Financial StatementsAC plus CUnderstanding the Income StatementC and C@ow to 3ead a Balance Sheet:C presented earlier in this series.> The difference between an income statement and a statement of cash flows is roughly analogous to the difference between a credit card statement and a chec(boo( ledger. & credit card statement includes charges that haven"t been paid off yet: while an updated chec(boo( ledger indicates where cash has been spent and whether there"s enough to pay off debts li(e a credit card bill. Similarly: a company"s e?penses and revenues are recorded on an income statement: regardless of whether cash has changed hands yet. & statement of cash flows: on the other hand: traces where cash came from and where it was used. The statement also separates cash generated by the normal operations of a company from that gleaned through other investing and financing activities: as seen in the sample statement of cash flows of the hypothetical KHL .orp. Statement of cash flo!s fo' 012 Co'p3 fo' the yea' ending Dec3 456 5777 (in millions) 'om ope'ations -et income 0lus depreciation 0lus decrease in receivables <less increase> 5ess increase in inventories 0lus increase in accounts payable <less decrease> -et increase <decrease> in cash from operations 'om investing 5ess purchase of e7uipment 'om financing Bonds issued -et increase <decrease> in cash .ash at beginning of year .ash at end of year Cash "low "rom operations# $$ <3,> #* 3s. )# < ,$> 3s.3$ , <#$> < $> $ ,

.ash flow from operations starts with net income <from the income statement> and adFusts out all of the non'cash items. Income and e?penses on the income statement are recorded when a company earns revenue or incurs e?penses: not necessarily when cash is received or paid. To figure out how much cash the company received or spent: net income is adFusted for any sales or e?penditures made on credit and not yet paid with cash. 6?amples of these adFustments are shown above. KHL had 3s.#$ million in sales to customers who had not paid the company as of the end of the year: so this increase in receivables is subtracted. KHL also reported 3s. , million in depreciation e?pense <the portion of long'lasting assets: such as buildings: that is written off each year>G depreciation is not a cash item: so it is added bac(. Finally: KHL purchased 3s. $ million of additional inventory that was not sold as of year end. Because the inventory was not sold: it is not considered an e?pense. But because cash was used in the purchase: the 3s. $ million is subtracted from net income. -et cash received from KHL"s operations: after the above adFustments: was 3s. , million. Cash "low "rom investing .ash flow from investing includes cash received from or used for investing activities: such as buying stoc(s in other companies or purchasing additional property or e7uipment. KHL .orp. had no cash receipts from investing in ))) but spent 3s. ,$ million to purchase e7uipment. Cash "low "rom "inancing .ash flow from financing activities includes cash received from borrowing money or issuing stoc( and cash spent to repay loans. KHL .orp. received 3s. $$ million in cash from issuing bonds in ))). Si8ing up ope'ating pe'fo'mance 4f the three main sources of cash flow: analysts loo( to that from operations as the most important measure of performance. If operations alone don"t generate positive cash flow: that may be cause for concern. In addition: a decrease in cash flow due to a sharp increase in inventory or receivables can signal that a company is having trouble selling products or collecting money from customers. @owever: analysts loo( at the relative amount of these changes if accounts receivable have gone up by the same percentage as sales revenues: the increase may not be unusual.

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Risk Re!a'd Ragas

/henever we tal( about investments: there is always some ris( associated with all of them. 3is( is the most dreaded word in all the financial mar(ets across the globe. &ny person: who is operating in the financial mar(ets: in whatever capacity: has to

face ris(. So the 7uestion in most minds is: what e?actly this RIS9 isA /hat does it meanA In general terms: ris( means any deviation from e?pectations. In Financial parlance: ris( means any deviation from the e?pected returns. !ore specifically: the probability that the returns from any asset will differ from the e?pected yields is the ris( inherent in that asset. /e all face ris( in our lives in one way or the other. So lets have an understanding of the ris( Risk inhe'ent in e-uity investments 67uity investment is the most ris(y investment in all the financial mar(ets. So one needs to have an understanding of ris(s associated with e7uity investments. Broadly: there are two types of ris(s associated with e7uity investments: vi;.: systematic ris( and unsystematic ris(. 5ets have an understanding of these two types of ris(s.
Systematic 'isk: or the mar(et ris(: as it is called: this is the variation in the return on any scrip due to mar(et movements. For e?ample: suppose the Government announces a corporate ta? cut or rise across the board: it is going to effect all the stoc(s in the mar(et in the same way. This is the systematic ris( of scrip: which e?ists because of mar(et movements.

There is nothing much one can do about systematic ris( of a security because it arises due to some e?traneous variables. But there still e?ists some techni7ues: which help to hedge against the systematic ris( of a security. & good measure of an assetEs systematic ris( is its Beta. Beta is calculated by regressing the returns of a particular asset on mar(et returns. It can be interpreted as: say the beta of a stoc( is .#,: then whenever the mar(et moves by M: the stoc( will move by .#,M. ;nsystematic 'isk: is the variation in the return of a scrip due to that scrip specific factors or movements. For e?ample: say the Government announces ta? sops to companies in a particular sector: it is going to effect the prices of the stoc(s of companies which are operating in that sector and not all the stoc(s. !easuring ris( /e can measure ris( in two ways J 6? post and 6? ante ris( measurement. 6? post measurement is done after the happening of an event and 6? ante measurement is done before the happening of an event. %< post Risk /hen ris( is measured e? post: it is measured as Dariance from the mean value. That is: it is the statistical measure of Dariance associated with the returns on a particular asset. For e?ample: if one wants to measure ris( associated with a particular stoc(: he will ta(e the returns generated on the stoc( over a period of time and then he will find out the variance in the return of that particular stoc(. That variance will be the ris( of that stoc(. %< ante Risk

/hen it is measured e? ante: it is measured as the probability that the returns from an asset will deviate from the mean or the e?pected returns. For this: if the variable has a normal distribution: the Theory of -ormal distribution can be easily applied to find out the probability of this deviation. 4therwise subFective estimates of the probability have to be made. For e?ample: say the changes in a stoc( price have normal distribution. 4ne can ta(e the mean return based on the past return of the stoc(. Then: using the Standard -ormal probability distribution: he can find out the probability of the return on that stoc( falling below that mean or e?pected return. If the stoc( price is not normally distributed: then he will have to ma(e subFective estimates of probabilities of getting a particular return. Using that: he can find out what is the e?pected return on that stoc(. Then the ris( on that stoc( is the statistical measure of variance in return of that stoc( from the e?pected return. )edging 'isks associated !ith e-uity investments 3is( @edging encapsulates all the activities re7uired to ensure that the e?posure: one is having: on account of the ris(: doesnEt transform into loss. That is: the e?posure is only a notional loss: which might transform into actual loss on happening of a particular event: but if necessary steps are ta(en to control: manage and diversify away the ris(: this e?posure can be controlled. &ll the activities underta(en to do so collectively comes under the purview of ris( hedging. In the following section: we present some of the commonly used techni7ues for managing ris(s%
;se of de'ivatives: 8erivatives are most commonly used to hedge against the mar(et ris(. The use of the type of derivative instrument depends upon the e?pectations. &n e?ample will ma(e the point clear. Say: you have $$ 3eliance shares: the mar(et price of which is presently 3S. 3$$. -ow you e?pect that the price of 3eliance might go down in the future due to some reason. To hedge yourself against this ris(: you can buy a 0ut option on 3elianceEs stoc( and loc( in a price. If the price actually falls: you can sell those shares at the price you contracted through 0ut option. If you e?pect prices to rise and you want to buy shares in the future: you can buy a .all option on 3elianceEs stoc(.

To learn more about derivative basics: clic( here <a lin( to our derivative channel>. &s of now: the use of derivatives on individual securities is not allowed in India. Sometime bac(: the use of any derivative instrument was not allowed in India. But now the S6BI has allowed the use of Inde? Futures on BS6 and -S6. Soon: these Futures instruments will start trading on other e?changes also. &nd in due of course of time: the entire range of derivative instruments will be allowed in India.
"aking a po'tfolio: To guard yourself against mar(et ris(: you can also ma(e a portfolio of stoc(s whose returns are negatively correlated with each other. If you ma(e a portfolio of two stoc(s whose correlation co' efficient is J <minus >: then your mar(et ris( is minimi;ed.