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How To Understand A Balance Sheet: Part 2

90% of investors lose money in the stock market despite their sincere intentions of making money. Isn’t it frightening?

If you ask the 90% if they know what the business owns or owes, it is most likely that they will give you a blank stare.

The 10% who profit consistently are different as they are interested to find out what their businesses own or owe before investing.

So, how do we get such information? The answer lies in a company’s balance sheet. If you are new to it, do not fret. I will share a few things you need to know about balance sheets so that you can interpret it easily.

Here’s part two on analysing a balance sheet. You can read part one over here.

Current Ratio

How do we tell whether a stock has adequate financial resources to pay its bills over the next 12 months?

The answer lies in calculating a stock’s current ratio. It is easily calculated by dividing a stock’s current assets by its current liabilities. Let me illustrate.

If you have $100,000 in savings and need $100,000 in living expenses a year, then, your savings could last you one year. Thus, your current ratio is 1.

If you have $500,000 in savings, then, your current ratio is five as your savings could last you five years. As such, the higher a stock’s current ratio, the greater its ability to meet its short-term financial obligations. It thus has more financial resources to invest, expand or pay out dividends to its shareholders.

Debt-to-Equity Ratio

How do we assess a stock’s debt level?

The answer lies in calculating a stock’s debt-to-equity ratio. It is easily calculated by dividing a stock’s non-current liability by its equity. Here’s an example.

If you put down payment of $200,000 and borrowed $800,000 to buy a property worth $1 million, then, your debt-to-equity ratio is 4 or 400%. Obviously, if you place a higher down payment, let us say $500,000, then, your debt-to-equity ratio would be 1 or 100% as you have more equity invested in the property.

So, is high debt-to-equity ratio a good thing?

Not necessarily. It is only good if the stock is able to use debt to generate higher profits for shareholders. It is disastrous if a debt is misused. For investors who are risk averse, they would prefer stocks with the low debt-to-equity ratio as these stocks are financially steadier since they have lesser debt obligations.

Foolish Summary

You might feel that the financial statement is just a bunch of numbers. However, these numbers are there to tell us a story.

As an investor, it is our job to translate the numbers into a story that we can understand. By turning the numbers from the balance sheet into the ratios shown above, we would have a better idea of the strengths and weaknesses of 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. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.