Friday, 25 March 2016

Making sense of Balance Sheet & Cashflow

This is very important stuff if you want to make sense of the annual reports that the companies you invested in send yearly.


Making sense of a company's Balance sheet - 
it should all balance up


In a Balance sheet there's two parts of equivalent values:

1) Total Assets $ =
2) Total liabilities and Equity

This is because Equity = Total assets - Total liabilities, so both values would be the same.

Equity is also known as net asset or net worth of a company. It comprises of two parts - Retained earnings (accumulative net income) and Treasury stocks

Reference: http://news.morningstar.com/classroom2/course.asp?docId=145091&page=7&CN=

An important ratio that you can derive from here is this:

Current asset / Liabilities

If it's more than 1.5, the company is generally doing okay (not neck-high in debt).


Statement of Cash flow - 
show me the money $

Cash flow is important because it tells you how much cash a company generates. If a company makes profit but did not generate any spare cash in the process, it might spell financial trouble ahead.

The Cash flow statement (CFS) has three parts to it:

1) Operating activiities

2) Investing activities

3) Financing activities


Free Cash Flow = Cash from Operations - Capital Expenditures


Reference: http://news.morningstar.com/classroom2/course.asp?docId=142913&CN=COM&page=4


Note that CFS is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which on the income statement and balance sheet, includes cash sales and sales made on credit, as well as assets depreciation.


From a book which I borrowed. Can't recall the book's title.


Sometimes you will come across this term called "working capital". Working capital represents the difference between a firm’s current assets and current liabilities (current means short-term eg within 1 year). Something like a subset of Equity.  [Reference: https://www.investopedia.com/ask/answers/071114/how-do-changes-working-capital-affect-companys-cash-flow.asp]

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Just bear in mind that sometimes things are not as simple as they look because there is such a thing call 'financial engineering' where some figures could be created to make things look good and yet legit. For example, manipulation of ROE through aggressive stock buybacks despite in high debt, no re-evaluation of company's fixed asset etc.

Also look out for any third-party related transactions and look out for exceptionally big figure of good wills. These would require more in-depth reading for a good understanding.

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