What must investors look for in the balance sheet of a company?

So you are now the proud shareholder of an Indian company and you have just received the first annual report of the company by email. Obviously, as a first timer, you may find the financial statements of the company to be a lot of jargon. But remember there are a lot of insights hidden in the balance sheet. A balance sheet gives an ownership perspective; in the sense that it shows what the company owns and what it owes. A balance sheet also gives you a time perspective; in the sense that it shows you a breakup of short term and long term assets as well as short term and long term liabilities. Here are 5 things you should actually be reading in a company balance sheet..

Check the ratio of current assets to current liabilities..
As the name suggests, the word current refers to the short term (period of less than 1 year). Current assets typically include cash, short term investments, inventories and trade debtors. Current liabilities, on the other hand, include short term loans and trade creditors. Normally, the first thing you check in a balance sheet is the current ratio. The current ratio is the ratio of the current assets to your current liabilities and shows how liquid are your working capital cycle to finance your payables. Your current assets must be sufficient enough and liquid enough to pay current liabilities when they become due. Paying current liabilities out of long term funds is bad balance sheet management. Normally, a current ratio of 1.5 to 3.0 is considered to be comfortable. Below 1.5, there may be a worry in terms of servicing. Current ratio above 3 is indicative of sub-optimal utilization of funds.

Check out the assets turnover ratio..
This is the measure of the efficiency of utilization of your assets and is measured as the ratio of your net sales to your total assets. A higher asset turnover ratio is positive as it indicates that the assets of the company are being churned more aggressively and more efficiently to generate sales and profits for the company. Normally, companies with a high asset turnover ratio tend to have higher ROEs and therefore tend to get better valuations in the market. A lower asset turnover ratio is not only indicative of weak sales conversion but also indicative of a large asset base that is not exactly productive. This measure is a good indicator for manufacturing companies.

What is the size and cost of debt?
This is, perhaps, one of the most important factors that determine the solvency and the financial viability of the company in the long run. We are referring to long term debt here. A debt equity ratio of up to 2:1 is considered to be acceptable. This is again truer of manufacturing companies as companies in sectors like IT normally tend to be zero-debt companies. Infosys and TCS are cases in point. You also must be cautious if the debt on the balance sheet is high-cost debt as that can make the company more vulnerable to shocks. This is evident from the interest cost in the P&L account. Also be cautious of foreign currency denominated debt as it can snowball in the event of the dollar strengthening.
 
Is the company focusing on tangible or intangible assets..?
This is an interesting distinction. Intangible assets include items like goodwill, patents, trademarks and brands that can be leveraged to get a better valuation in the market. Normally, these are intellectual properties and sectors like IT, pharmaceuticals and FMCG companies have these properties in abundance. Remember, that not all intellectual properties are reflected in the balance sheet but these can help get better valuations when the company is looking at mergers / acquisitions etc.

Get a hang of the contingent liabilities..
These are also referred to as off-balance sheet liabilities. They are not shown as liabilities in the balance sheet but can become liabilities subject to certain conditions. These are normally shown as a separate item under the notes to accounts. These include pending legal cases, risk of open derivative positions etc. One must also read the auditor’s report for any qualifications about the non-presentation of contingent liabilities. We have seen in the case of Enron where the undisclosed liabilities of faulty derivative transactions led to the bankruptcy of the company. This may appear to be small but can be quite important in the overall context.

Reading through a balance sheet carefully can throw up a mountain of intelligence and insights to you as investors. The can go a long way in helping you understand your investments better. After all, well informed investors normally tend to be successful investors!