Starting and Running a Profitable Investmeent Club

 

Chapter 4

Analyzing the Balance Sheet

 

Here are some cool things to look for in the Balance Sheet:

 

1) working capital = current assets - current liabilities

 

We would like to see a number large enough to keep the company out of financial difficulty if business falls off for a period, and enough to buy something should an opportunity arise.

 

2) current ratio = current assets / current liabilities

 

A ratio of less than 2 to 1 is often a danger sign, except for companies with no inventory, or for utilities. These may operate successfully at a ratio of 1 to 1 or even less.

 

2 to 1 is typical of manufacturing companies.

 

a higher ratio is desirable if inventory is subject to wide price fluctuations.

 

Too high may mean they are not employing their cash to its best use.

 

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Track the current ratio back a few years and compare it to other companies in the industry.

 

3) quick assets ratio = (current assets - inventories) / current liabilities

 

This is especially important for companies that have high-priced items and might not be able to liquidate quickly.

 

Track quick assets ratio over a period of years and compare to other companies

 

4) inventory turnover = cost of goods sold / average inventory at cost

 

(if average inventory at cost is not available, use the ending inventory figure on balance sheet)

 

(if inventory levels are stable, average may be computed by adding beginning and ending inventory and divide by 2)

 

This ratio tells how many times their inventory is completely sold and replaced in a year.

 

This should increase over time and be higher than competitors.

 

5) plant turnover = sales / (property + plant + equipment)

 

This should also increase over time. If a company increases property, plant, equipment then we should see an increase in sales.

 

6) book value = value of common stock + retained earnings + surplus reserves

 

This value has no direct relationship to market value; we will use this value in chapter 5

 

7) next we have several ratios.

Define total capitalization = value of bonds + preferred stock + common stock + capital surplus + retained earnings

 

bond ratio = face value of bonds / total capitalization

preferred stock ratio = value of preferred stock / total capitalization

 

common stock ratio =

(value of common stock + capital surplus + retained earnings) / total capitalization

 

Generally, a company should have less than 50% of capital in bonds and preferred stock, and less than 25% in bonds.

 

Utilities can have up to 70% or 75% ratio of debt and preferred stock to total capital, but this makes them sensitive to interest rates.

 

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A company with a high ratio of bonds and preferred stock is highly leveraged.

 

If the company is leveraged, see if the return on equity is higher than the return on total capital structure.

 

If return on equity is higher, then shareholders are benefitting.