Investors would be aware that looking at company financial statements are one of the important parts of stock analysis. Ratios derived from such financial statements are not the be-all and end-all to the decision-making process but they play a vital role. They provide an understanding of the financial health of the company and ease the evaluation process. You would have read about some key stock ratios in an earlier post.
There are three components to a financial statement, namely,
- Balance Sheet
- Cash Flow
This series will take a look at all three of them in some detail and address a few ratios that can be deduced from them.
Consolidated Balance Sheet
The balance sheet of a financial statement provides information about a company’s assets, liabilities, and shareholders’ equity on a quarterly or annual basis. The balancing formula for the sheet is as follows:
Total Assets = Total Liabilities + Shareholders’ Equity
The “Assets” section of a balance sheet will include cash, cash equivalents, short-term investments, inventories, account receivables, plant and equipments, and intangibles. Assets that are non-physical in nature such as intellectual property (patents, brand names, etc.) and goodwill (the amount paid in excess of its book value for an asset) are grouped under intangible assets.
The “Liabilities” section involves short and long-term debts, account payables, and other debt resulting in a cash outgo. The “Shareholders’ Equity” section would comprise of common stock, preferred stock (if applicable), retained earnings, and additional paid-in capital.
There are several ratios that could be computed from the data available on a balance sheet.
This is a measure of the total liabilities to the total assets of a company and differs from the current ratio that only considers current assets and current liabilities.
Debt Ratio = Total Liabilities / Total Assets
The lower the debt ratio, the better the financial shape of the company. A ratio higher than 1.0 means that the company has more debts than assets. However, startup firms will have a high debt ratio as they may not have started to see the fruits of their labor yet.
Debt to Equity Ratio
This metric measures the ratio of total liabilities to the shareholders’ equity.
Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity
The lower the debt to equity ratio, the better for shareholders as this implies that the investors have a fair share of equity contributing to the company’s bottomline.
This is a measure of the long-term debt of a corporation to its total capital (assets). Total assets include long-term debt and shareholder’s equity.
Capitalization Ratio = Long-term Debt / (Long-term Debt + Shareholders’ Equity)
The lower the capitalization ratio, the lesser the chance of financial instability as this indicates that the amount of financial leverage is low. A ratio of 1.0 would mean that there is no shareholder equity in the company and the total assets reported are based on debt.
Do you read financial statements? Do you use the above ratios in your decision-making process apart from others (to be discussed in following posts)? Did any one of the above become a red flag, i.e., a high ratio, to reject a stock?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.