How to Evaluate a Company's Balance Sheet

For stock investors, the balance sheet is an important financial statement that should be interpreted when considering an investment in a company. 

The balance sheet is a reflection of the assets and the liabilities owned by the company at a certain point in time. 

The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capitalisation structure.

Read more at:
https://www.investopedia.com/articles/basics/06/assetperformance.asp

About Asset Allocation – a guest post

Many small investors jump into the market – usually near bull market peaks – without doing any prior homework about how the stock market or mutual funds industry operates. They end up with a portfolio full of questionable investments that teaches them a very costly lesson – there are no short cuts in life, and definitely not in the field of investments.

Now that the stock market is hovering near its all-time peak, Nishit’s guest post addresses the important concept of asset allocation. Investing without an asset allocation plan is like going to a railway station and hopping on to the first train that is leaving a platform without knowing where it is headed. You may get somewhere, but it may not be a place you want to visit.

The thrill of adventure of not knowing where you are going – physically or financially – may be fun for a while, but expensive in the long run. Following an asset allocation plan takes away most of the uncertainty of your investment future, and ensures that you stay invested through the ups and downs of the market.

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Today, we explore an important pillar of financial investing: asset allocation. Before we move further, let me ask you one of the most fundamental questions: Why do we work for a living? Why do we spend stressful hours commuting, tolerating unpleasant bosses, enduring long caffeine-fuelled meetings? Do we do it because we like doing it? Some of us may love our work greatly, but for most it is a way of earning money. The path to an early retirement is proper asset allocation.

Assets are of various types. They could be equity, debt, real estate, gold, and cash. The idea is to earn an optimum rate of return by taking the right amount of risk. The risk profile of every person is different. Riskier assets generally yield more returns, but not everyone can take the same amount of risk. A person aged 30, having a good job can withstand some capital erosion but a retiree at 65 with no avenues of earning money other than those generated from his assets can’t afford to lose money.

A thumb rule of asset allocation is that a person can invest upto (100 - age)% in equity. For example, a 30 year old can have 70% asset allocation to equity while a person who is 65 years old should avoid investing more than (100 - 65 =) 35% in equity. Now, thumb rules are meant to be only a guideline.

While making an asset allocation plan, one must also look at the ease of liquidation of the assets. How many days would it take to liquidate the assets and have hard cash in hand? Equities and gold ETFs normally take 3 days from the date of selling to get cash in hand. Debt can usually be redeemed in about a week’s time, be it mutual funds or fixed deposits – sometimes with a penalty of 1-2%.

The trickiest asset is real estate. It requires legal documentation, involves part transaction in ‘black’ money and has almost no transparency. Also, when the prices start falling you may find no buyers. I am a strong advocate of the policy of owning only the house you live in. Else, invest in REITs or stocks of real estate companies.

The trick is to treat all your assets as a fund and find out what the rate of return on the portfolio is. Any return above 16% (twice the 10 year government bond rate) is an excellent return on investment. The idea is to get rich slowly, step by step.

The cardinal rule to be followed is preservation of capital, followed by return on investment. For a 30 year old, the portfolio could be 20% gold, 40% equity and 40% fixed income. For a 60 year old the equity could be 20%, rest in gold and debt.

An example of retiring early and doing what one wants is Lakshmi Ramchandran, who blogs at http://vipreetinvestments.blogspot.com/. She took Voluntary Retirement from her bank in 2001 and is doing what she loves most. She does Technical Analysis, trades the market and enjoys life at her own pace.

Further insights on asset allocation can be found here: http://www.investopedia.com/articles/pf/05/061505.asp

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

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About assets, liabilities and the curious case of HUL

Dissecting balance sheets and getting to the root of financial statements are not really the stuff that gets me all energised. Assets, liabilities, inventories, cash and bank balances are insipid compared to the engineers' arsenal of double derivatives (no pun intended) and triple integrals.

But as uninteresting as brushing one's teeth, or eating 'karela' (bitter gourd) may be, they are a necessity for good hygiene and health. Likewise, being able to read between the lines of balance sheets, Profit & Loss and Cash Flow statements is a necessity for better health of one's stock portfolio.

Today's discussion was triggered off by reader Rishi's query last week. Why is it that a stalwart company like HUL is showing negative Net Current Assets on its balance sheet year in and year out? I was taken aback. How could that be possible? A market bellwether and leading FMCG multinational has more liabilities than its assets? After generating huge cash flows and paying continuous dividends?

Unfortunately, I could not locate last year's Annual Report. It came more than a year back and after a quick review to check every thing was in order, I didn't need to refer back to it any more. So I checked up at the Rediff money site, and guess what? Five straight years of negative Net Current Assets.

Now, any semi-intelligent high school graduate will be able to tell you that Net Current Assets (i.e. Current Assets - Current Liabilities) should be zero at worst, never negative. In other words, any company should own enough readily accessible assets to cover what it owes to others in the near term (within the financial year).

Ideally, the ratio of Current Assets to Current Liabilities should be 2 or more. But 1.5 is an acceptable number. That would indicate that a company has more than enough money to pay off the loans due and its creditors.

Unable to locate the HUL Annual Report to check the details, I checked up ITC's report instead. Sure enough, the Current Assets to Current Liabilities ratio was a respectable 1.58. Cummins India's? 1.67. Glaxo Pharma's? 1.91.

Now I was getting a bit jittery. Without the Annual Report, how will I respond to Rishi? Suddenly, I remembered my friend Nasir, who is an experienced Chartered Accountant in a multinational company. He had kindly offered to help me out with accounting intricacies if I faced problems.

Nasir's response was prompt and detailed. HUL's modus operandi is unique in corporate India. At the beginning of the year, they collect advance payments from their distributors. No distributor has the temerity to say 'No'.

These substantial advance payments are reflected in their books as a "Current Liability", though the company has no intention of paying back the money. What they do instead, is to supply their various products to the distributors throughout the year against the advance payments.

Consequently, the 'Debtors' figure under the head of "Current Assets" is negligible or nil. And the company is always flush with cash. Funny thing is, I knew about all this because an acquaintance used to be a HUL distributor.

Why do the HUL distributors effectively fund the company's operations? This is what happens when a company becomes so large and so popular, that it almost becomes a monopoly and can negotiate advantageous business terms with its suppliers and distributors.

Does all this smack of sharp business practices? Not at all. The company has worked hard over the years to create good products and establish strong brands. They spend hundreds of Crores in advertising to maintain their leadership position in the FMCG segment.

Why shouldn't they cut the best deal possible for themselves, and their shareholders? Microsoft does it. I would do it if I was able to garner that kind of market domination.

After all, a company exists to make profits. Not to win popularity contests. If it can do so without violating the law of the land, more power to them. Whether its Current Assets are more or less than its Current Liabilities.

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