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 31st Mar' 2000:

As on 31-3-00
Assets
Gross Block 3978.55
Net Block 2790.57
Capital WIP 66.72
Investments 454.33
Inventory 610.81
Receivables 1546.81
Other Current Assets 3673.67
Balance Sheet Total 9142.92
Liabilities
Equity Share Capital 434.12
Reserves 5815.65
Total Debt 2096.69
Creditors and Acceptances 393.91
Other current liab/prov. 402.55
Balance Sheet Total 9142.92

Let us take a look at each of its components.

Assets

Gross block is the sum total of all assets of the company valued at their cost of
acquisition. This is inclusive of the depreciation that is to be charged on each asset.
Net block is the gross block less accumulated depreciation on assets. Net block is
actually what the asset are worth to the company.

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 books as capital work 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 stock 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 back to the company. Other current assets include all
the assets, which can be converted into cash within a very short period of time like
cash in bank etc.

is the owner's equity. It is the most permanent source of finance for

Equity Share capital
the company. Reserves include the free reserves of the company which are built out of
the genuine profits of the company. Together they are known as net worth of the
company.

Total debtincludes the long term and the short debt of the company. Long term is for
a longer duration, usually for a period more than 3 years like debentures. Short term
debt is for a lesser duration, usually for less than a year like bank finance for working
capital.

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

Role of Balance Sheet in Investment Decision making

After analyzing the income statement, move on to the balance sheet and continue
your analysis. While the income statement recaps three months' worth of operations,
the balance sheet is a snapshot of what the company's finances look like only on the
last day of the quarter. (It's much like if you took every statement you received from
every financial institution you have dealings with — banks, brokerages, credit card
issuers, mortgage banks, etc. — and listed the closing balances of each account.)

When reviewing the balance sheet, keep an eye on inventories and accounts
receivable. If inventories are growing too quickly, 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 lax credit policies or poor internal controls. Finally, take a
look at the liability side of the balance sheet. Look at both long-term and short-term
debt. Have they increased? If so, why? How about accounts payable?

After you've done the numerical analysis, read the comments made by management.
They should have addressed anything that looked unusual, such as a large increase
in inventory. Management will also usually make some statements about the future
prospects of business. These comments are only the opinion of management, so use
them as such.

When 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 benchmark as a
basis for analyzing your portfolio next time. Spending a few minutes like this each
quarter reviewing your holdings can help you stay on track with your investment
goals.

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Company Valuation

Whenever people talk about equity investments, one must have come across the
word "Valuation". In financial parlance, Valuation means how much a company is
worth of. Talking about equity investments, one should have an understanding of
valuation.

Valuation 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)

NAV or Book value is one of the most commonly used methods of valuation. As 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 NAV per share.

One way to calculate NAV is to divide the net worth of the company by the total
number of oooutstanding shares. Say, a company’s share capital is Rs. 100 crores
(10 crores shares of Rs. 10 each) and its reserves and surplus is another Rs. 100
crores. Net worth of the company would be Rs. 200 crores (equity and reserves) and
NAV would be Rs. 20 per share (Rs. 200 crores divided by 10 crores outstanding
shares).

NAV 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. One can use any of
the two methods to find out NAV.

One can compare the NAV with the going market price while taking investment
decisions.

Discounted Cash Flows Method (DCF)

DCF is the most widely used technique to value a company. It takes into
consideration the cash flows arising to the company and also the time value of
money. That’s why, it is so popular. What actually happens in this is, the cash flows
are calculated for a particular period of time (the time period is fixed taking 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
What is Fundamental Analysis?

Fundamental analysis is the analysis, wherein the investment decisions are taken on
the basis of the financial strength of the company. There are two approaches to
fundamental analysis, viz., E-I-C analysis or the Top Down approach to Fundamental
analysis and C-I-E analysis or the Bottom up approach. In the following section, we
explain both these approaches.

Economy-Industry-Company Analysis

In the Top down approach, first of all the overall Economy is analyzed to judge 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 Economy analysis is important. The output of the Economy 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.

Measuring a Company's Financial Health

Gaining a true picture of a company's finances means not only scrutinizing the
financial statements but also analyzing 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 explains how to read a company's financial statements. Measures 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. Book value can be
figured as assets minus liabilities, or assets minus liabilities and intangible items such
as goodwill; either way, the figure that results is the company's net book value. This
is contrasted with its market capitalization, or total share price value, which is
calculated by multiplying the outstanding shares by their current market price.

You can also compare a company's market value to its book value on a per-share
basis. Divide book value by the number of shares outstanding to get book value per
share and compare the result to the current stock price to help determine if the
company's stock is fairly valued. Most stocks trade above book value because
investors believe that the company will grow and the value of its shares will, too.
When book value per share is higher than the current share price, a company's stock
may be undervalued and a bargain to investors. In fact, the company itself may be a
bargain, and hence a takeover target.

Price/earnings ratio (P/E) is the more common yardstick of a company's value. It

is the current stock price divided by the earnings per share for the past year. For
example, a stock selling for $20 with earnings of $2 per share has a P/E of 10. While
there's no set rule as to what's a good P/E, a low P/E is generally considered good
because it may mean that the stock price has not risen to reflect its earning power. A
high P/E, on the other hand, may reflect an overpriced stock or decreasing earnings.
As 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 measure of solvency

Debt-to-equity ratio provides a measure of a company's debt level. It is calculated

by dividing total liabilities by shareholders' equity. A ratio of 1-to-2 or lower indicates
that a company has relatively little debt. Ratios vary, however, depending on a
company's size and its industry, so compare a company's financial ratios with those
of its industry peers before drawing conclusions.

Measures of liquidity

Current ratio. Current assets divided by current liabilities yields the current ratio, a
measure of a company's liquidity, or its ability to meet current debts. The higher the
ratio, the greater the liquidity. As a rule of thumb, a healthy company's current ratio
is 2-to-1 or greater.

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Cracking Ratios

Ratio Analysis

Ratio Analysis is the most commonly used analysis to judge the financial strength of
a company. A lot of entities like research houses, investment bankers, financial
institutions and investors make use of this analysis to judge the financial strength of
any company.

This analysis makes use of certain ratios to achieve the above-mentioned purpose.
There are certain benchmarks fixed for each ratio and the actual ones are compared
with these benchmarks to judge as to how sound the company is. The ratios are
divided into various categories, which are mentioned below:

Profitability ratios

Profitability ratios speak 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 equity (net profit divided by net worth of the
company) and return on investment (operating profit divided by total assets). As
obvious from the name, the higher these ratios the better for the company.

Solvency ratios

These ratios are used to judge the long-term solvency of a firm. The most commonly
used ratios are – Debt Equity ratio (total debt divided by total equity), Long term
debt to equity ratio (long term debt divided by equity). While the accepted norm for
debt equity ratio differs from industry to industry, the usual accepted norm for D/E is
2:1. It should not be more than this. For certain industries, a higher D/E is accepted,
e.g., in banking industry, a debt equity ratio of 12:1 is acceptable.

Liquidity ratios

These ratios are used to judge the short-term solvency of a firm. These ratios give
an indication as to how liquid a firm is. The most commonly used ratios are – Current
ratio (all current assets divided by current liabilities) and quick ratio (current assets
except inventory divided by current liabilities). The accepted norm for current ratio is
1.5:1. It should not be less than this.

Turnover ratios

These ratios give an indication as to how efficiently a company is utilizing 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

Valuation ratios give an indication as to whether the stock is underpriced or

overpriced at any point of time. The most commonly used ratios are Price to Earnings
(P/E) ratio and price to book value (PBV) ratio. But care has to be taken while
interpreting these ratios. While P/E ratio of a company should be compared with the
industry P/E and the P/E of the competitors, it is the PBV that can distort.

While a lower PBV usually means a lower valuation, there can be a case where a low
PBV can be because of a very huge capital base of the company. In such a case, the
stock might be overvalued but the PBV will indicate that the stock is undervalued. On
the other extreme, a higher PBV usually means overvalued stock but that can also be
because the company has a very small capital base. So care has to taken while
interpreting these ratios.

Coverage ratios

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 taxes) and debt service coverage
ratio (earnings before interest and taxes plus all non cash charges divided by interest
outstanding plus the term loan repayment installment). The acceptable norm for
DSCR is 2:1.

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Profit Loss Fundas

Income statement is the snapshot of a company's operational performance for a
particular period of time. It takes the company's revenues and expenses and gives
profits as output. Take a look at the income statement of Global Telesystems:

As on 31-3-00
Net Sales 6065.51
Operating Income 6265.63
Operating Profit 2116.57
Operating PBDT 1700.44
Operating Profit before Tax(PBT) 928.63
Non-Operating Income 1562.62
Extraordinary/Prior Period income -171.23
Tax 30.00
Profit after tax(PAT) 2290.02
Cash Profit 3061.82
Dividend-Equity 100.40

Let us take a look at the different components of a Income statement of Global Tele.

First item is Net sales. Net sales is simply the product of quantity sold by the company and the selling price per
unit. This figure is net of excise duty to be paid on the goods sold.

Next comes operating expenses. These are the expenses incurred in producing the goods like labor, fuel, power
etc. The difference between the net sales and the operating expenses is the operating profit, which is a
commonly used statistic to judge the operational performance of the company.

Next comes Operating profit before Tax, which is nothing but operating profit less interest and depreciation. Non
operating income is the income that is not earned in the normal course of business operations. For example,
interest earned on any investments made etc. Extra ordinary income is non recurring income that is earned only
once and there are not any chances of earning that income again like profit on sale of any asset etc.

Cash profit is PAT plus any all non cash charges, i.e., charges that don't entail actual cash outflow but they are
only notional charges like depreciation, writing off preliminary expenses etc.

Role of Earnings in Investment decisions

Once you have got an understanding of Income statement, you are ready to be your
own analyst. Each quarter, companies release their earnings, and, for companies
using the traditional calendar-year approach, the quarter ended on New Year's Eve.
Earnings season is a great time to re-evaluate your current holdings to make sure
the companies you own are living up to your expectations. But before earnings are
even announced, you might want to review why you made the investment in the first
place.

Whenever you buy a stock, write down in three or four sentences why you are doing
so. State your reasons as objectively as you can. You might want to list such items
as revenue growth, sustainability of earnings or growth over time, increased market
share, increased gross margins, price targets for the stock or any other reasons you
have for making the investment. For example, you might write, "I am buying XYZ
Corp. because I think earnings will grow at a rate of 20% per year and that the
price/earnings multiple will increase from its current level of 16 to between 22 and
25."

By writing down your assumptions and your goals, you'll create a benchmark 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.

Now take a look at the earnings. The earnings per share (EPS) number is a good
place to start. The EPS is the total net profit of the company divided by the number
of shares of stock outstanding. But don't just look at the actual EPS and compare it
to the expected EPS. Pull out your calculator and crunch some numbers.

First of all, has the number of shares outstanding changed significantly? Has the
company bought back a large chunk of its stock? If so, earnings may have improved
on a per-share basis, but may have stayed flat or even declined in real terms. Next,
you should be on the lookout for any one-time charges. You will want to remove the
effect of the one-time charge, as it only creates noise and makes year-over-year
comparisons more difficult. Any one-time charge or gain will be stated in per-share
amounts as a footnote. Just subtract it from the EPS if it is a gain, or add it back if it
is a loss. Once you have the EPS number exclusive of one-time items, you can
compare it to the EPS from the same quarter last year to see how much growth has
occurred. Compare the growth figure of your company to others in the same
industry.

Once you have gotten a good feel for the EPS, it's time to look at the actual numbers
on the income statement. Here are some questions to ponder while you have your
calculator in hand. What does the growth rate in sales look like? How was it last
quarter? Are gross margin percentages better or worse than they have been
historically? Are expenses increasing faster than sales?

Using your written benchmarks for the stock, create a couple of additional questions
to help you compare the company's results with your own stated assumptions.

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Cash Flow Curries

Think of cash as the lifeblood of every business. Without cash flow, no business can
function and without an accurate picture of cash flow, no investor can have a
complete picture of a company.

A 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 expenses are paid when incurred. (For an explanation
of financial statements, see "What's the Deal With Financial Statements?" plus
"Understanding the Income Statement" and "How to Read a Balance Sheet,"
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
checkbook ledger. A credit card statement includes charges that haven't been paid
off yet, while an updated checkbook ledger indicates where cash has been spent and
whether there's enough to pay off debts like a credit card bill. Similarly, a company's
expenses and revenues are recorded on an income statement, regardless of whether
cash has changed hands yet. A 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 XYZ Corp.

Statement of cash flows for XYZ Corp. for the year ending
Dec. 31, 1999 (in millions)

From operations
Net income Rs.30
Plus depreciation 15
Plus decrease in receivables (less increase) (20)
Less increase in inventories (10)
Plus increase in accounts payable (less decrease) 0
Net increase (decrease) in cash from operations 15

From investing
Less purchase of equipment (150)

From financing
Bonds issued 100

Net increase (decrease) in cash (35)

Cash at beginning of year 127
Cash at end of year Rs. 92

Cash flow from operations:

Cash flow from operations starts with net income (from the income statement) and
adjusts out all of the non-cash items. Income and expenses on the income statement
are recorded when a company earns revenue or incurs expenses, not necessarily
when cash is received or paid. To figure out how much cash the company received or
spent, net income is adjusted for any sales or expenditures made on credit and not
yet paid with cash.

Examples of these adjustments are shown above. XYZ had Rs.20 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. XYZ also reported Rs.15 million in depreciation expense
(the portion of long-lasting assets, such as buildings, that is written off each year);
depreciation is not a cash item, so it is added back. Finally, XYZ purchased Rs.10
million of additional inventory that was not sold as of year end. Because the
inventory was not sold, it is not considered an expense. But because cash was used
in the purchase, the Rs.10 million is subtracted from net income. Net cash received
from XYZ's operations, after the above adjustments, was Rs.15 million.

Cash flow from investing

Cash flow from investing includes cash received from or used for investing activities,
such as buying stocks in other companies or purchasing additional property or
equipment. XYZ Corp. had no cash receipts from investing in 1999 but spent Rs.150
million to purchase equipment.

Cash flow from financing

Cash flow from financing activities includes cash received from borrowing money or
issuing stock and cash spent to repay loans. XYZ Corp. received Rs.100 million in
cash from issuing bonds in 1999.

Sizing up operating performance

Of the three main sources of cash flow, analysts look 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. However, analysts look
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 Reward Ragas

Whenever we talk about investments, there is always some risk associated with all of
them. Risk is the most dreaded word in all the financial markets across the globe.
Any person, who is operating in the financial markets, in whatever capacity, has to
face risk. So the question in most minds is, what exactly this RISK is? What does it
mean?
In general terms, risk means any deviation from expectations. In Financial parlance,
risk means any deviation from the expected returns. More specifically, the probability
that the returns from any asset will differ from the expected yields is the risk
inherent in that asset. We all face risk in our lives in one way or the other. So lets
have an understanding of the risk

Risk inherent in equity investments

Equity investment is the most risky investment in all the financial markets. So one
needs to have an understanding of risks associated with equity investments. Broadly,
there are two types of risks associated with equity investments, viz., systematic risk
and unsystematic risk. Lets have an understanding of these two types of risks.

Systematic risk: or the market risk, as it is called, this is the variation in the return on any scrip due to market
movements. For example, suppose the Government announces a corporate tax cut or rise across the board, it is
going to effect all the stocks in the market in the same way. This is the systematic risk of scrip, which exists
because of market movements.

There is nothing much one can do about systematic risk of a security because it
arises due to some extraneous variables. But there still exists some techniques,
which help to hedge against the systematic risk of a security.

A good measure of an asset’s systematic risk is its Beta. Beta is calculated by

regressing the returns of a particular asset on market returns. It can be interpreted
as, say the beta of a stock is 1.25, then whenever the market moves by 1%, the
stock will move by 1.25%.

Unsystematic risk: is the variation in the return of a scrip due to that scrip specific
factors or movements. For example, say the Government announces tax sops to
companies in a particular sector, it is going to effect the prices of the stocks of
companies which are operating in that sector and not all the stocks.
Measuring risk

We can measure risk in two ways – Ex post and Ex ante risk measurement. Ex post
measurement is done after the happening of an event and Ex ante measurement is
done before the happening of an event.

Ex post Risk

When risk is measured ex post, it is measured as Variance from the mean value.
That is, it is the statistical measure of Variance associated with the returns on a
particular asset. For example, if one wants to measure risk associated with a
particular stock, he will take the returns generated on the stock over a period of time
and then he will find out the variance in the return of that particular stock. That
variance will be the risk of that stock.

Ex ante Risk

When it is measured ex ante, it is measured as the probability that the returns from
an asset will deviate from the mean or the expected returns. For this, if the variable
has a normal distribution, the Theory of Normal distribution can be easily applied to
find out the probability of this deviation. Otherwise subjective estimates of the
probability have to be made.

For example, say the changes in a stock price have normal distribution. One can take
the mean return based on the past return of the stock. Then, using the Standard
Normal probability distribution, he can find out the probability of the return on that
stock falling below that mean or expected return.

If the stock price is not normally distributed, then he will have to make subjective
estimates of probabilities of getting a particular return. Using that, he can find out
what is the expected return on that stock. Then the risk on that stock is the
statistical measure of variance in return of that stock from the expected return.

Hedging risks associated with equity investments

Risk Hedging encapsulates all the activities required to ensure that the exposure, one
is having, on account of the risk, doesn’t transform into loss. That is, the exposure is
only a notional loss, which might transform into actual loss on happening of a
particular event, but if necessary steps are taken to control, manage and diversify
away the risk, this exposure can be controlled. All the activities undertaken to do so
collectively comes under the purview of risk hedging.

In the following section, we present some of the commonly used techniques for
managing risks:

Use of derivatives: Derivatives are most commonly used to hedge against the market risk. The use of the type
of derivative instrument depends upon the expectations. An example will make the point clear. Say, you have 100
Reliance shares, the market price of which is presently RS. 300. Now you expect that the price of Reliance might
go down in the future due to some reason. To hedge yourself against this risk, you can buy a Put option on
Reliance’s stock and lock in a price. If the price actually falls, you can sell those shares at the price you
contracted through Put option. If you expect prices to rise and you want to buy shares in the future, you can buy
a Call option on Reliance’s stock.

To learn more about derivative basics, click here (a link to our derivative channel).

As of now, the use of derivatives on individual securities is not allowed in India.

Sometime back, the use of any derivative instrument was not allowed in India. But
now the SEBI has allowed the use of Index Futures on BSE and NSE. Soon, these
Futures instruments will start trading on other exchanges also. And in due of course
of time, the entire range of derivative instruments will be allowed in India.

Making a portfolio: To guard yourself against market risk, you can also make a portfolio of stocks whose
returns are negatively correlated with each other. If you make a portfolio of two stocks whose correlation co-
efficient is –1 (minus 1), then your market risk is minimized.