Does large debt on the Balance Sheet make a company's stock a risky investment?

It is that time of the year when Annual Reports of companies will be hitting mailboxes. Instead of just checking the dividend amount and tossing the report in the recycle bin, it may be worthwhile to go through the report.

At the very least, the balance sheet, P&L, cash flow statement and the notes to accounts should be studied. These will reveal the financial health of a company.

One of the things that get many companies into trouble is trying to grow too fast, too soon. Many tech companies had fallen prey to the syndrome of 'grabbing eyeballs' instead of having a solid business plan that would lead to cash generation.

They had taken on a huge amount of debt to gain market share quickly by expanding globally or by acquiring competitors. Their subsequent bankruptcies were caused by the inability to service their debts.

Even the well-established houses of Tatas and Birlas made gross errors of judgement by financing their acquisitions of overseas competitor companies through large debt.

But what if taking on large debt to buy out a competitor actually results in increasing market share and enabling a move up the value chain? Tata Motors did that successfully by acquiring Jaguar-Land Rover from Ford.

So, how does a small investor decide if large debt on the Balance Sheet of a company makes investment in its stock risky or not? 

One way is to look at the Interest Coverage ratio. Another is to look at the Return on Capital Employed (RoCE) ratio. The higher the ratios the better. Both these ratios should be compared with other companies in the same sector.

Read more. 

How to do 'due diligence' before buying a stock

The Indian economy is back on the growth path. Liquidity is sloshing around. FIIs are buying. The stock market has shaken off the bears and is rising towards its lifetime high. 

You are either a smart investor who entered at lower levels and are enjoying the bull ride. Or, you are a new investor feeling anxious whether to enter the market now or wait for a correction.

Either way, you may be interested in catching hold of the 'next Eicher Motors' or the 'next Page Industries' or the 'next Yes Bank' and becoming a 'Crorepati'.

Successful investing requires more than luck and pluck. It requires serious hard work, discipline and patience.

Most of the hard work - or 'due diligence' - should be done before buying a stock. What is 'due diligence'? It is the process of investigating all available information about a company whose stock you are thinking of purchasing.

What does 'all available information' include? Financial information available from Annual Reports. Stock price history available from stock exchanges. Brokerage reports. Industry reports. Reputation of company management.

That seems like a lot of 'available information' to investigate. What if one doesn't have the time or know-how to do all this investigating? Isn't there a shortcut?

Fortunately, there is. You can leave the 'due diligence' to experienced fund managers by starting a SIP in a diversified equity fund or a balanced fund with a track record of 5 years or more.

You will still get the benefit of good long-term returns - provided you hold on to the fund units for the long-term - without the hassle of going through Annual Reports, Brokerage Reports and Price charts.

In fact, a SIP in a good equity fund or balanced fund is the best way for new investors to start investing in the stock market.

However, if researching companies excite you and making outsize returns from the stocks of less known and 'undiscovered' companies gets your adrenaline pumping, then performing 'due diligence' won't seem like a chore.

So, prepare a 'watch list' of companies based on their past, current and likely future performances and start your 'due diligence' to prepare a shorter 'buy list'.

Haven't done proper 'due diligence' before? 
Read the article by Ryan Barnes: Due Diligence In 10 Easy Steps

12 Things You Need To Know About Financial Statements

When stock markets are in turmoil, like now – Sensex up 300 points one day and down 500 points the next – the tendency of many small investors is to get paralysed by fear. They tend to sell their stock holdings just when the market nears a bottom.

Fear is a strong emotion that is difficult to control – specially when your hard-earned money is going down the drain. It is also the single most important reason why small investors don’t make as much returns from their stock holdings as they should.

There is of course another important reason why returns from stock investments are often meagre: poor selection of stocks. In a bid to generate outsize returns, small investors chase ‘cheap’ or momentum stocks with non-existent fundamentals.

So, how does one select good stocks? By learning the basics of fundamental analysis. And how does one go about doing that? By studying annual reports of companies. Annual reports analysis can be tedious and boring – but it is an essential skill if you want to invest in stocks.

It requires nothing more than common sense, knowledge of junior school arithmetic and basic accounting concepts. It isn’t rocket science. Thanks to the Internet, annual reports are readily available on company web sites.

To help you get started, here is an article from investopedia.com. Bookmark the article if you are a new stock investor. There are lots of useful links in it that you may wish to go through.

The article can help seasoned investors as well. It is always good to brush up on your fundamental analysis skills. And, who knows? You may even pick up a few new insights.

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How to read an Annual Report

How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

Why technical and fundamental analysis are the two feet of a stock portfolio

Have you tried to stand on one foot for any length of time? Unless you are an expert in hathayoga, you won’t be able to do it for more than a few minutes. Even if you are able to balance yourself for 10 minutes on one foot, what purpose will be served? You won’t get anywhere! Like you, your stock portfolio needs to use two feet – technical analysis and fundamental analysis – to achieve success.

Being an engineer by training, technical analysis always appealed to me more when I started investing in the stock market. Semi-logarithmic charts, trend lines, symmetrical and right-angled triangles, rectangles, parallelograms, Fibonacci retracement levels were familiar terminology. I took to them like a duck to water.

Well, not quite. After losing a ton of money, I came to the fairly simple conclusion that familiarity with the terminology was not the same as knowledge of the subject matter. Understanding different chart patterns is not of any use unless you know which stock charts to study. But the alternative wasn’t intellectually stimulating enough.

Fundamental analysis meant dissecting the contents of Annual Reports. No exponentials or double integrals to apply one’s math skills. Just a bunch of numbers that needed to be added and subtracted and divided to unravel the secrets of well-disguised financial performances. Low-level clerical stuff – or so I thought.

Finally, a broker friend opened my eyes. He only had a B. Com degree but was rolling in cash and driving around in new cars. So I asked him what the secret was. His answer shook me up. Just plain grunt work, he said. Wading through annual reports to find financially strong companies that generate cash and don’t require too much capital to function.

How do you decide when to buy or sell?, was my next question. This is where a bit of knowledge of technical analysis can help, he responded. You have to first determine the trend – whether up, down or sideways. Moving average crossovers and support-resistance levels can then be used to determine entry and exit points.

That is all there is to it. No rocket science. Just school-level arithmetic, including familiarity with graphs and the discipline to go through annual reports in detail. Don’t have time and energy for all this hard work? Avoid individual stocks; buy mutual funds.

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The 7 Steps to Success in Stock Market Investments

Before readers get all excited, I have a disclaimer. The 7 Steps to Success is a sure-fire, fail-safe method for making money in the stock market over the long-term. What it isn't is a short-cut to success. There aren't any short-cuts to success.

To achieve success in any endeavour - be it in the field of education, or sports, or any profession - requires discipline, an ability to concentrate on the important issues, diligence, hard work, persistence and patience.

The stock market is no exception - contrary to what most investors may think before they jump in feet first and lose their shirts. I have been there and done that, and learned the hard way.

Without much further ado, here are the 7 Steps to Success in Stock Market investments:-

Step 1: Develop a reading habit. Business magazines, pink papers and books on investments. Not every one likes to read - particularly if the language is other than one's mother tongue. For success in the stock market, you don't need to know everything. But you need to know where to go to find the answers. Before investing a single Rupee, read 'One Up on Wall Street' by Peter Lynch.

Step 2: Learn how to read an Annual Report. The most important starting point should be the Cash Flow Statement, followed by the Balance Sheet and the Notes on Accounts. The real information is usually hidden there. Most investors take a cursory glance at the Director's Report, may be the Management Discussion and Analysis, and the Profit and Loss statement to check the dividend amount.

Step 3: Refresh your knowledge about grade school arithmetic. If percentages, ratios, graphs, the concept of compound interest and pages full of numbers scare you witless, you won't be much good at stock investing. Since you learned most of the stuff in school, you can and should be able to re-learn the stuff.

Step 4: Make an honest assessment of your financial situation and risk tolerance. Every investor has different requirements. If you are already bent over with the weight of EMIs and credit card debt, the worst thing you can do is try to make some quick money in the stock market. You will get into a deeper hole. Put the 'can't afford to lose' portion of your savings in fixed deposits, PPF, NSC, Post Office MIS schemes.

Step 5: Prepare an asset allocation plan, and stick to it. Within the equity portion of the allocation, maintain 75-90% in a core portfolio of fundamentally strong large-cap stocks/funds. The balance 10-25% can be in a satellite portfolio of mid and small-cap stocks/funds. (If you don't know how to allocate your assets, you probably haven't read my eBook. It is FREE and you can get it by sending me an email request.)

Step 6: Once you have built a good portfolio, monitor it once a week at most. Just as a sapling won't grow faster into a tree if you stare at it every day, neither will your portfolio. Enterprise and activity may be a requirement in other fields, but they are a detriment to investment success. Learn how to be actively passive - if you can pardon the oxymoron.

Step 7: Warren Buffett revealed an investment success secret - 'Be greedy when others are fearful, and fearful when others are greedy'. He is an acknowledged master, and I am his unknown follower. But here is another investment success secret - 'Cut your losses quickly and let your profits grow slowly'. You can do that by learning to set a stop-loss and a trailing stop-loss respectively. (The concepts are explained in my FREE eBook.)

About Current Ratio and Quick Ratio

In-depth interpretation and analysis of financial ratios are best left to CAs and CFAs. For ordinary small investors, understanding the concepts behind the Current Ratio and the Quick Ratio enables a reasonable assessment of the financial health of a company.

If you are the kind of investor who only looks at the Profit and Loss statement in an Annual Report to check the Net Profit and Dividend amounts before tossing it in the dustbin, then you need to make a little more effort to become a better investor.

Look at the Cash Flow statement to check that the Cash Flow from Operating activities is positive. Then, calculate the Current and Quick ratios.

Current Ratio

This ratio is obtained by dividing the Current Assets figure in the Balance Sheet by the Current Liabilities. A good ratio is between 1.5 and 2. A ratio of 1.0 or less may mean that the company may face difficulty in meeting its short-term debt obligations. A ratio of 3 or more may not necessarily be better, as explained below.

The range of Current Ratios are different for different industries and sectors. So, comparing the ratio with the company's competitors will give a better idea of industry norms and the company's position.

Current Assets typically comprise: inventories, cash and cash equivalents, accounts receivables (debtors), loans and advances.

Current Liabilities include: interest payments, accounts payables (creditors), provisions for payments of taxes, dividends, retirement and other benefits.

The Current Ratio indicates whether the company will be able to meet its payment obligations that become due within the year. It can do this by using the cash, or by collecting payments from its debtors, or by quickly turning over inventory to generate cash.

Too high a Current Ratio could mean:

(a) too much inventory - which may not be good because it may be valued at a cost which can't be realised later; this is particularly true of the retail industry, where inventories often need to be marked down for discount sales due to spoilage or change in fashion

(b) poor debt collection, or inadequate credit facilities from suppliers -indicating management inefficiency or a poor business model.

Quick Ratio

Due to concerns mentioned above, the Quick Ratio is often used as a better test of a company's liquidity position. That is why it is some times called a Liquidity Ratio or Acid Test Ratio.

The Quick Ratio is obtained by subtracting inventories from the Current Assets figure, before dividing by the Current Liabilities.

A ratio of 1.0 is considered good enough. It can be higher for certain industries, but too high a ratio may indicate management inefficiency.

What is the reason for subtracting inventories? The first reason has been mentioned already - the cost of inventories in the Balance Sheet may not reflect the real value. The second, and more important reason is that it may not be easy for a company to turn inventory into cash fast enough to meet payment obligations.