This post covers the second part of fundamental analysis after analyzing the income statement. If you haven’t read part one, I suggest you read it here. Analyzing the Balance Sheet for a company is essential to understanding the entire company’s financial structure by understanding its assets and liabilities. We will continue learning with the example of Netflix(NFLX) used previously for continuity.
Let us first take a look at the assets side or the left side of the balance sheet
An instant look at the Total Asset numbers shows that Netflix has increased its assets by nearly 170% in the last few years. What are Assets?
Assets are things that a company owns – this includes any cash on hand, investments, property or real estate(fixed assets), any goods/products held in inventory etc. While these assets can be deemed as tangible assets, meaning they are physical in nature, a company can also possess intangible assets. These type of assets are not physical in nature, such as – intellectual property, brand recognition, patents, copyrights and goodwill. Another category is Other Current Assets that are not classified as investments, property or intangible assets, but can be converted to cash within a business cycle. An example of this type of asset would be bond issue costs.
Based on the data above, it is clear that Netflix has shown consistent growth in expanding its assets over time, thereby implying that the business is generating sufficient revenue for growth and sustainability. This information often helps in identifying growth stocks.
Now let’s move on to looking at the liabilities and equity of Netflix. The most basic accounting principle here is
Assets = Liability + Equity
While assets help us understand what the company owns, liabilities are what the company owes. This comprises bank loans, interest charges, money owed to creditors or suppliers(accounts payable). Long-term debt is usually paid beyond 12 months while short-term and other current liabilities refer to debt without a specific time line but due within a 12 months timeline. While total current liabilities hold small significance, it is the long-term debt that is important to consider for an investor. We shall see how this number is used to compute an important financial ratio.
The data below clearly shows that while the company is growing, it is also increasing its debt over time. Reasons for more debt should be further researched by following the company’s annual report for its future growth plans.
Equity defines ownership in a company. Thus, whatever is left from Assets after subtracting Liabilities, must be owned by equity. This includes all owners of the company including investors who even possess a single share of the company. The value of equity, unlike liabilities is not fixed, and can change as the value of assets changes.
Common stock is also referred to as shares. As you can see that over the years the number of shares has increased from 1 million in 2014 to over 1.8 million in 2018. This is a bad sign for an investor. This is because Netflix is issuing more shares to the public, thereby diluting or reducing part of its ownership. While this cannot be used as the only reason to reject an investment, one needs to be aware of reasons why the company wishes to raise more funds. For example, Netflix would like to raise funds by selling equity to conduct more research on targeting a global audience to provide better services. If the company succeeds in its research, it will have access to a larger audience, thereby increasing revenue and will drive the stock price higher.
Retained earnings refer to the profit the company earned after paying any dividends or distributions to investors. A growing company often uses these retained earnings to fund future activities for additional growth. It can also use these earnings to pay off debt or simply hold them in reserve when the company has projected a loss in the future. Once a company reaches a stable and mature position, it usually starts paying dividends to its customers and does not rely heavily on its retained earnings.
Dividend payout is a big sign for a stable growing company for an investor. Looking for companies that pay dividends is also a great way to build a long term positive returns portfolio.
Now that we have understood both sides of the balance sheet, one of the key ratios we can determine is the Debt to Equity Ratio.
D/E = Total Debt ÷ Total Stockholders Equity
D/E = 6,499,432 ÷ 3,581,956 = 1.81
This ratio is extremely important when analyzing your investment. A high debt to equity ratio means that the company is aggressively trying to finance its growth with debt. This often leads to volatility in the stock market and one must beware before investing in high debt companies. Generally a D/E value of less than 1 is favorable for an investment.
Thus by looking at the balance sheet we can determine the following:
1. Growing assets indicate growth
2. Growing Debt and Common Equity could be bad and prompt further research
3. High D/E ratio indicates higher volatility
Now that we understand a company’s financials, in the next topic I will cover some of the key ratios and terminology related to the stock market and how an investor can use it to his advantage. Until then …
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Next in this Series ⇒ Understanding Indices & Ratios