Wednesday, August 31, 2011

How financial reports of companies can be used value shares?

Balance Sheet

Balance Sheet is a very important document our of all the three financial reports. The balance sheet as the suggests indicates a balance between the Assets and Liabilities. It also indicates how the funds are generated by the company to run the business.

If funds are generated by issuing share, by taking loan from banks, or else the company has sufficient cash reserves to fund its work in progress. Generally a combination of share capital, bank loan and cash reserves work in unison to fund the company day to day working.

The fund generated by company by means of share capital and their total cash reserves is called Net worth of the company. The higher the net worth the better. By summing up what we have learnt in this paragraph, the source of funds can be computed by the formula as indicated below:

Source of funds = Net worth + Loan

If a company is able to run its business with zero loan it means the total business is funded by its net worth. This is the reason why it is said the higher the net worth the better. By net worth we means cash reserves and share capital.

Generally companies work hard to develop a huge reserves of cash. Out of the total net profit made by companies after tax, a portion of profit is transferred to the cash reserves as indicated in balance sheet. This way every year the cash reserves column go on increasing.

Of course this can happen only when the company is making profits, in case of loss there will be no fund available to be transferred to cash reserves. So as long as the Net worth (cash reserves) of the company it growing it will directly influence the share value in the market.

 As an investor it is very important to track the new worth ( cash reserves) of a company and compare this value with market price of share. Let us take an example:

- Net worth of company A: Rs 28,000 Crore
- No of shares outstanding of company A: Rs 190 Crore

- Net worth/ share of company A: Rs 147.3
- Market price of share of company A: Rs 240

Suppose any individual wants to buy the total company as a whole (100% shares) then he shall pay at least Rs 147.3 per share to own total ownership of the business. The valuation of share on basis of net worth is a very indicator for investors to know that what minimum they should pay for each share. In case the market price of share is below this net worth price it means that the company’s share is undervalued.

But this is a rare case, most of the time you will find that the market price of share is always 2 or 3 times higher than the net worth values. Now why this happens? Why investors are ready to pay higher than the calculated financial new worth of the business? The reason behind this is the future growth prospects. If investors are confident that the share value will grow faster than the present trend (growth in net worth in past 5 years) then they will pay a slightly higher price today to own these shares.

Now the question is how to know that whether the company will grow faster in future? It is almost like predicting future, but by studying the profit and loss account (another financial report) and ratios we can gauge future. That will be discussed later in this article.

In short we can say that the balance sheet of a company will help the investors to know how well the company is placed ‘today’ in term of its net worth. Two company with the same level of sale turnover but one having the higher net worth (or cash reserves) will be the better company to invest in. As net worth of a company is developed year after year, hence we can assume that the net worth figures are reflective of past performance and health of a company.

Profit & Loss Accounts

As Balance sheet (net worth & cash reserves) of a company talks about the over all growth of company since its inception till date, the profit and loss account of company gives a glimpse of how well the company has performed in the last year.

The profit and loss account also has very valuable information’s for investors which will help to gauge the possible growth possibilities of future. Basically the profit and loss accounts of the company shows how company is generating their income, effecting their expenses and what level of profit the company is able to generate. In short we can summarize the profit and loss accounts by the below formulae:

Income = Expenses + Profit

The most valuable piece of information of profit and loss accounts is EBIT (Earning before interest and tax) values. This value can be calculated by obtaining the operating profit (Income minus expenses) and subtracting from it the net depreciation.

The value of EBIT is a very strong indicator that what level of earnings are generated by the company year after year form its operation (less depreciation). This value of EBIT can be jointly used with two figures of Balance Sheet to get a very important value. This value is called return on invested capital.

The return on capital is calculated by the following formulae:

ROC = EBIT / (Net working capital + Net fixed asset)
Net working capital = Receivables + Inventory

If ROC is say 12% then compare this with risk-free interest (7% on bank deposits) and with inflation (10% as on today). A return on capital of 12% means that not only it beats inflation but it also has capacity to generate higher returns than risk-free returns.
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