Most businesses classify assets and liabilities into sub-categories. Assets are typically broken down into (1) current assets, (2) plant and equipment and (3) other assets. Liabilities are generally listed as (1) current liabilites and (2) long term debt.
Because there are many different ways to account for and value assets, and because liabilites can be accounted for in different ways, a balance sheet can be a difficult thing for a potential purchaser or investor to utilize properly. Balance sheets can also be misleading (without being illegal or fraudlent) to a person or company deciding whether to purchase another entity. However, there are some fundamental measurements, readily calculable from a balace sheet, which can prove useful.
The ability of a company to pay its debts can be analyzed using the current ratio . Divide current assets by current debts. Current assets are usually listed separately on the balance sheet and represent cash, receivables, marketable securities, prepaid expenses and other liquid assets. Current liabilites are those expenses which must be paid in the same time frame used to define current assets. If the company treats a receivable as a current asset because it is due to be paid within one year, it must treat the salaries that will be due its employees during that year as a current liability. Other types of current liabilites typically include income taxes, sales taxes and accounts payable.
Thus dividing current assets by current liabilities gives a ratio which measures the ability of a company to pay its debts in the short term. The current ratio is most useful to the investor or potential buyer who compares the current ratio of a potential investment to the industry average. If the average current ratio in the retailing industry is 2 to 1 (the average retailer has liquid assets equally to twice the amount of bills to be paid in the near term), an investor may wish to avoid retailer X which has a current ratio of .5 (current assets are half current liabilites).
The debt to equity ratio of a company is another useful measure of corporte health. To calculate the ratio, divide a corporation's total liabilities by the total amount of shareholder's equity. As with the current ratio, the debt to equity ratio of a company should be compared with the debt to equity ratios of its competitors.
The profitability of a company can be compared to that of its peers by comparing net profit margin. The net profit margin is calculated by dividing net income by net sales for any given year. This ratio is in many ways an indication of how will the company is run by mangement . If company X produces more income than company Y as a percentage of sales, it is doing something better in terms of management.
Often times earnings will be announced before interest and taxes reconciled. Earnings Before Interest, Taxes and Appreciation is given the acronym EBITA. Some analysts prefer to use EBITA, rather than net profit based analysis, because interest payments and tax deductions, both of which vary, are automatically excluded from the analysis thereby giving a less distorted view of corporate profitability.
Return on Common Equity (ROE) is calculated by dividing the net earnings of a company by total shareholders' equity of the common shareholders. Stated differently, the net profits of a company are divided by the value the company would have if all of its debts were paid off and its assets were liquidated. Therefore, ROE measures how well the management of a company uses its assets to produce profit.
Corporations release earnings per share data on a quarterly basis. Earnings per share is calculated by dividing net income by the average number of shares outstanding during the quarterly period.
The price to earnings ratio or PE is reported in most daily newspapers. It is calculated by dividing the current stock price by the total earnings of the corporation for the past four quarters combined. The PE ratio reported in the paper is therefore sometimes called the trailing PE ratio because it uses profit data from the past. PE ratios can also be calculated by using analysts estimates of future profits. This is the forward PE ratio an can be calculated using the current market price of a stock and estimates of net profit in the next four quarters.
The trailing PE ratio can therefore indicate how much investors are willing to pay for a company's earnings. Companies with high PE ratios are those which, for whatever reason ,the market is placing a premium. Usually, a high PE is an indication that investors think the company is going to be earning more in the future. Indeed, companies with no earnings and even those with losses often see the price of their shares soar when investors think better days are ahead. Likewise, a low PE can be an indication that the market thinks the company will not be able to sustain its earnings in the future.
As with any financial ratio, it is important to compare the price to earnings ratio of a company against its peers. Also, using financial ratios alone to make investment decisions do not guarantee investment success. For example, company X may produce more profit relative to sales compared to company Y because the former company has failed to invest in new equipment which will increase profits in the future. In that circumstance, company Y may well be a better long term investment.
A company's book value can also be calculated from the balance sheet. Book value per share is the net assets represented by each share of stock. To calculate the book value of a company with only common shares, take the total shareholders' equity from the balance sheet and divide by the number of outstanding shares. The number of authorized shares is not relevant to this calcuclation, because only the issued shares, or outstanding shares, represent ownership in the company. It is important to compare a corporation's book value with that of its competitors in the same industry.
Just as earnings can be compared to the current price of a stock by using a PE ratio the book value of a share of common stock can be compared to the current price. The Price/Book value ratio is computed by dividing the current price per share by the book value per share. Companies can and do trade at prices both above and below their book value. Likewise companies can and do sell for prices above or below book value.
Copyright 2003, The Gauss Law Firm, P.C.