Want to check on a stock? Here's how

n  Want to buy a stock? we explained what a Profit and Loss Account is all about and what it tells you about the company.

Now it's time to turn to the balance sheet.

• Things you must know before buying shares

A sample balance sheet

The balance sheet is divided into two main sections: the source of funds (from where the money has come) and its application (what it has been used for).

• 5 rules when buying stocks

Capital

From where does a company get its money? Share capital is one obvious source.

Capital is the amount that the owner has in the business. As the business grows and makes profits, it adds to its capital.

This capital is subdivided into shares.

So if a company's capital is Rs 10 crore (Rs 100 million), that could be divided into 1 crore (10 million) shares of Rs 10 each.

Some of the shares are held by the promoters (people who started the business) and the rest by the investors (people like you and me or mutual funds and other financial institutional).

Note that share capital has remained the same in the above example for 2004 and 2003, which means that the company did not raise capital (issue fresh shares) in 2004.

Reserves

When a company makes profits, it can either hold back the profits or distribute it as dividends to its shareholders.

Let's say a company earns a profit of Rs 1 crore. It could deploy half the money for buying new machinery and raw materials and paying back some of the loans. The rest can be distributed as dividend.

A company's retained profits (profits that do not go out as dividend) is transferred to Reserves. This is why the Reserves in the balance sheet keep on rising every year for profitable companies. If the company makes a loss, however, reserves go down.

The company's capital and retained profits together make up shareholders' funds in the business. This is also known as net worth. When net worth is divided by the number of shares the company has, we get the Net Asset Value per share.

Loans

Loans are another source of funds. 

Secured loans are where the lender has a charge over the company's assets. Loans from banks fall in this category. So if the company has no money to pay back the loan, the bank can take away, say, the machinery or land and sell it to regain its money.

Unsecured loans are those which do not have a specific charge over the company's assets. Fixed deposits taken by companies are an example of unsecured loans. If the company cannot repay the investors of fixed deposits their money, they lose it totally and cannot claim anything back.

• What a stock split is all about

Application of Funds

This part of the balance sheet tells you how the money has been utilised.

Gross Block

The company generally will use the bulk of its money to buy assets.

Gross block is the sum total of all the assets of a company valued at the cost of acquisition.

Depreciation

Over time the value of certain fixed assets - equipment and machinery - dips as it is being utilised. The estimated wear and tear of the equipment is referred to as depreciation.

Net Block

When you deduct the depreciation on those fixed assets, you get net block.

Current liabilities are the sundry creditors (those to whom the company owes money) and provisions (expenses for which the company has set aside a sum of money, eg for income tax, dividends, rent etc, but for which payments have not yet been made).

You will have to deduct current liabilities from current assets to arrive at net current assets.

Capital work-in-progress

This could be some construction, installation or expansion programme going on for which work is not yet completed.

Investments

The company also uses surplus funds to make investments - these could be in group companies or in mutual funds or in bonds or any other avenue.

• How to make money in shares

Compare figures

The way to read the balance sheet is to compare the figures with that of the previous year. Let's take a look at some of the changes in the example given above.

Observation: Loans have come down.
Implication: The company repaid some loans in 2003-04.

Observation: Gross block and capital work-in-progress has increased.
Implication: The company added to plant and machinery in 2003-04 and is continuing with capital expenditure (as shown by the capital work-in-progress). It has funded that work by drawing down its investments.

Observation: The company's shareholders' funds, or its net worth, has increased during the year.
Implication: Which means the company is making profits and retaining a part of them.

Observation: Inventories and debtors have risen.
Implication: This could mean either that the company has increased its scale of operations - sales have gone up - or it has become less efficient with its working capital, leading to a pile-up of goods and debtors. Perhaps it is having a tough time selling its goods. 

The Director's Report in the Annual Report and the P&L account will tell you whether the company's sales have indeed increased.

Stay informed

Reading the balance sheet will enable you to ask the right questions about a company's performance. And, together with the Annual Report and the P&L account, it gives a fair picture of the company's health.

Don't forget to check out the Auditor's statement and the Notes to the Accounts. These will tell you whether an attempt has been made to dress up the accounts to show a better picture.

Based on all this knowledge, you can then make an informed decision as to whether or not you should buy or even hold on to the company's stock.