Understanding Balance Sheets

When investing in the stock market a lot of preparation needs to be done before you go ahead and buy stocks in a particular company.

One form of preparation involves assessing the value of a company, and then deciding whether or not it will be a good short, medium or long term investment.

This can be done by looking at how profitable a company is, because if a company does not make any profit not only will the value of its shares in the stock market start to decline, but the very future of that company could be placed in jeopardy.

For example, prior the bear market of 2000-2002, many investors lost a lot of money in the investments they had made in the stock market because they invested in stocks of companies which were not making any profit.

Investors who had bought stocks in companies such as Enron and WorldCom were hit with very big losses when those companies collapsed, even though at the time many stock brokers were recommending that people buy their stocks because they were considered to be a good future investment.

In order to avoid making these same mistakes, you, as a stock market investor, need to have some basic knowledge of accounting so that you can decide for yourself whether or not to invest in a particular company, rather than relying solely upon the advice of “experts”.

Without this knowledge of basic accounting principles, you will have great difficulty becoming a successful stock market investor.

The good news however, is that this is not as hard as you might think. As long as you are able to keep a budget and manage your income and expenses, you should find using accounting analysis to evaluate stocks relatively simple to perform.

How To Analyse A Company Balance Sheet

A company balance sheet gives you the fundamentals of a company, from which you can quickly see what sort of financial condition they are in. This can be done by using the following equation:

Assets – Liabilities = Net Worth

Below you will find a list of several items that should be examined on the balance sheet.

1 – Assets

Look to see whether a company’s assets have increased from the previous year, or whether they have fallen due to a sale or a write-off.

Companies that have increasing assets over the years are likely to see the value of their stocks increase in the stock market.

2 – Debt

Debt is one of the most important things to look out for when deciding upon whether or not to invest in a company.

A company which has increasing amounts of debt is unlikely to have a secure future, unless they are able to get it under control.

Levels of debt may affect stock value immediately, or they may cause stock value to crash in the future once they reach a certain level.

3 – Derivatives

Derivatives do not constitute ownership of an asset, but rather a promise to convey ownership. Derivatives are often used to generate income, but carry very great risks that can increase liabilities.

When investing in the stock market find out if the company you want to invest in has derivatives, and if they do, the total amount.

In particular, look out for companies that have derivatives which are valued higher than the company’s net equity as this can cause many problems later on.

Barings Bank provides a good example of this, as their derivative problems ended up causing the bank to collapse.

4 – Equity

Equity is a company’s net worth, which is what is left over once you subtract assets from liabilities.

When investing in the stock market, look out for companies who have an increasing equity of around 10 percent each year.

Once you have looked at a company’s balance sheet, you should then be able to address the following questions:

What Are The Assets Of The Company?

Assets are anything that a company owns which could later be sold for cash. Such assets can be financial (e.g. cash), tangible (e.g. equipment) or intangible (e.g. copyrights).

What Are The Liabilities Of The Company?

Liabilities include anything that must be paid out to someone else. They are an expense, and lose the company money.

What Is The Company’s Net Worth?

Once you subtract assets from liabilities you can calculate a company’s net worth to determine its true value as an investment option.

Judging The Strength Of A Company

Looking at a company’s balance sheet is important, because in order to make successful investments in the stock market, you need to invest in companies which are likely to perform well in the future.

Some of the basic things you should be on the lookout for include the assets that a company has.

A strong and financially healthy company is likely to have increasing assets year after year, as this indicates they are growing because their product or service is in demand.

The liabilities a company has are also an important factor when undertaking investment decisions in the stock market.

If liabilities are growing at a faster rate than a company’s assets, then there is a good chance that company will experience financial difficulties in the future which could cause their stock value to plummet.

Perhaps most important however, is a company’s net worth as this tells you how much a company is truly worth.

Sometimes you will find companies in the stock market which have a high price per share, but once you begin to look at their fundamentals you can quickly see their stock price is overvalued.

Such overvalued companies can prove to be a risky investment because they are unlikely to have a secure long term future, the dot cot bust provides a good example of this.

So the bottom line when it comes to successful stock market investing is to always look at the fundamentals, because ultimately those are what drive the performance of a company in the stock market.