In order to truly understand the value of a company, it’s important that potential investors by able to look at where it stands financially. Luckily, this is not as tough as it sounds.
When you borrow money from a bank, you’ll need to list out the value of all your assets. You’ll also have to make a list of any major liabilities. The bank then uses these lists to decide how strong your financial position is. It examines the quality of your assets, like your house and vehicles, and then it places a value on them. Banks also make sure that any liabilities like credit card debt and outstanding mortgages on property are fairly disclosed and fully valued during this process. The total value of all assets, minus the total value of all of your liabilities, provides the bank with your total net worth, or equity.
When you need to evaluate the financial position of a company that’s listed, it’s a very similar process. Except that investors will need to add the additional step of pondering financial position and how it compares to the company’s current market value. Let’s examine this information carefully:
Lesson: An Introduction to Basic Analysis
Begin with a Balance Sheet
Much like your personal finance position, a business’s financial position is often defined solely by its liabilities and assets. However, the financial position of a company also includes the equity of the shareholders. This information is frequently compiled and presented to shareholders in a balance sheet.
If we suppose, for example, that were are taking a look at the finances of a fictitious retailer “The Outlet”, in order to fully evaluate its position. To complete this task, we thoroughly view the company’s annual report, which can typically be downloaded for free from the company website. The standard format for this balance sheet is to list assets, then liabilities, followed by shareholder equity. Current Liabilities and Assets
Often, liabilities and assets are split up into both non-current and current items. Current information is that with an expected life of 12 months or less. If we suppose that the inventories that “The Outlet” reported as of January 31, 2016 are expected to be sold within 2016. This will lead to the amount of inventory falling, while the amount of cash steadily rises.
Like many other retailers, store’s inventory is a giant part of its total assets, and this will need to be carefully monitored on a regular basis. Inventory is a real, viable investment of working capital. Companies may often try to minimize the value of inventory for a given level of sales. You’re looking for inventory that is being managed well. If “The Outlet” sees a 25% fall in the value of their inventory, as well as a 23% jump in sales, it is likely that they are doing a decent job of inventory management. This allows for positive contributions to their operating cash.
Current liabilities are the obligations that they’ll need to pay off within a year. This will include any existing obligations to suppliers, for taxes, employees, loan payments, and more. The most successful companies manage their cash flow well enough to ensure that there is cash available to meet these liabilities as they come due.
Learn About the Current Ratio
The ratio of current assets divided by current liabilities, is often used by financial analysts to learn about a company’s ability to pay its short term financial obligations. The ratio that is current will vary from industry to industry. However, it should not be so low that it suggests upcoming insolvency, or so high that it indicates too much of a cash build up, inventory, or receivables. This ratio will evolve in relation to past ratios, and should always be moving in a positive direction. Assets and Liabilities that are No Longer Current
Assets or liabilities that are labeled “non-current” are those that are expected to last longer than a year. In a company like “The Outlet”, it’s biggest asset is going to be the property, equipment, and plant it needs to operate and run a business.
Longer term liabilities might be related to leasing contracts for these items, as well as any other borrowing.
Book Value: Financial Position
If you subtract the total liabilities from the total assets, you’re left with the shareholder equity. This is the amount of the shareholder’s stake in the company, or the book value or accounting value of the company. It is made up of the capital contributed by over time and profits earned and retained by the company, including the portion of the profit not paid to shareholders as dividends. Market-to-Book
By taking the time to compare the company’s market value to its book value, potential investors can figure out whether a stock is trending at the appropriate price. This market-to-book multiple has become an important value tool for investors. Academic evidence suggests that businesses with lower market to book stocks often do better than those with higher numbers in this area. Low market to book multiple demonstrates that the business has a strong financial position, especially in relationship to its current price tag.
Comparison is also an important part of determining whether a business has a high or low market to book ration. You’ll need to compare the business’s you’re researching to other publicly listed retailers to get an idea of what you’re examining.
The End Story
Overall, a business’s financial numbers tell possible investors a lot about it’s well being and its future. Studying the business, as well as its annual report, is an important step for any investor who is interested in properly valuing a company.