For investors who are new to investing, scanning through financial statements and annual reports can be a tedious affair. The large numbers and barrage of information may sometimes overwhelm a new investor who may not be familiar with the financial jargon or industry-specific language.
To make things easier, I have decided to write a three-part article on what all investors should focus on when it comes to reading financial statements. This will be split into: (1) Balance Sheets, (2) Income Statements and finally, (3) Cash Flow Statements.
The balance sheet summarises a company’s assets, liabilities and shareholders’ equity. Through this information, we can learn how much debt a company is taking on, how much asset it owns and what portion of it belongs to shareholders.
This can give us a snapshot of a company’s financial muscle and whether it has enough cash to pay off its short-term borrowings. Now, let’s dive into three important aspects to focus on the balance sheet.
The amount of debt a company has incurred versus the shareholders’ equity can give us an idea of whether the company is prudent in managing its borrowings and risk.
We can calculate this by simply dividing a company’s total liabilities by its stockholder equity. A higher ratio indicates that a company has taken on more debt relative to its equity.
Companies that have a very high debt-to-equity ratio should be considered a red flag for investors.
Growing Shareholder Equity
When looking at balance sheets, it is also useful to compare the company’s current one with past years to see if the company has managed to improve its financial position overall.
One good way to assess this is by comparing the shareholder equity of a company over the years. A company that is able to consistently grow its shareholder equity through retained earnings is a hallmark of a strong and steady company.
Return on Equity
A company’s return on equity can give investors an idea of how effective a company is on employing its capital and using leverage to achieve better returns. It can be calculated by dividing net income by shareholders’ equity.
A company that can generate consistently high returns on equity may signal that it has a competitive advantage in its field. Having said that, it is important to assess how much debt a company has taken on to achieve such high returns.
This ratio should, therefore, be assessed together with the debt-to-equity ratio to give a better picture of the company’s returns.
The Foolish Bottom Line
The balance sheet can provide investors with a snapshot of a company’s financial well-being. Although it may look complicated to new investors, by focusing on some key aspects of the balance sheet, we can easily make sense of the numbers and find the important takeaways about a company.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.