While financial planners would normally advise you to take the mutual funds route to investment, many want to do it themselves. For such people, it's extremely important to look at certain parameters in the balance sheet that will help them decipher the financial situation better.
Ideally, start with balance sheet and give it a thorough reading. But often investors either don't make use of financials or rely on few select financial details to make their investment decision.
In a balance sheet, it is important to look at some important numbers. Then compare these numbers with historical data. Accordingly, a clearer picture will emerge on how the company is progressing. Also, the balance sheet will talk about other important features like the company's assets like building and furniture, receivables and liabilities.
Here are some important parameters that should give you a fair idea about the company's financial situation.
Cash and cash equivalent
The cash position of the company is immediately evident if one looks under this head in the balance sheet. Companies usually cannot manipulate it. As these cash balances are maintained with some bank, it can always be cross-checked by an external auditor. Of course, one cannot do much, if there is fraud of the magnitude of Satyam Computers, where cash balances were fudged. But as a thumb rule, more the cash value, higher the value of the company. In fact, it is also used to value organisations.
Debtors and creditors
There are people and entities that owe money to the company. In every business, all transactions do not involve immediate payment. These are known as debtors. Debtors are usually mentioned under receivables.
The figures mentioned gives an indication of the amount that is going to be collected. In case the financial conditions deteriorate, then an immediate impact could be seen here. Also, the company could be facing problems if the payment cycle is getting longer. That is, a large amount is getting locked up in an unproductive area.
Further, if a large part of the additional sales is added to debtors without collection, it means that the company is selling on credit. To get an overview of the company's financial health, compare the debts and number of debtors over years.
Just like a company owes money, it also needs to pay to various entities. These are classified under the head creditors. To know how the company is faring, compare the current amount and the number of debtors with previous years' data. This will tell you how the company is managing the payment cycle. If the numbers have gone up, it means the liability of the company is on a rise. This is not a good sign and may create hindrances in events such as raising capital.
Capital
The amount of capital in an organisation is an important parameter in arriving at a company's valuation. The amount of the capital also determines the kind of value that investors will give to the company in the stock market.
But it needs to be compared with the profits, to value a company. For instance, a profit of Rs 500 crore (Rs 5 billion) on a capital of Rs 5,000 crore (Rs 50 billion) would lower the valuation. However, a profit of Rs 200 on a capital of just Rs 50 crore (Rs 500 million) is likely to result in a better valuation.
Fund raising ability
Yet another way to judge any company's financial stability. There are two ways to raise money -- either through equity or debt. This means they can either go the financial institutions or raise money through the public. To do any of it, a company needs to have a sound financials.
To know whether the company can raise the required cash, look at the debt and equity on the books. For example, a company with an equity of Rs 100 crore (Rs 1 billion) and a debt of just Rs 5 crore (Rs 50 million) will find it easy be to finance a new venture or an acquisition. On the other hand, a company with an equity base of Rs 20 crore (Rs 500 million) and a debt of Rs 45 crore (Rs 450 million) will be viewed negatively, if it seeks a large amount of additional debt.
The writer is a certified financial planner.