Words are not to be feared, it is enough to find the balance sheets of a company and within these the amounts involved in the calculation of ratios to be able to use them. Next I explain what it is and what the balance sheets that interest us are made of to better understand the rest. Where to find the balance sheets or learn accounting, is not the object of this work, but to try to offer a useful tool to the investor and of course my respect for technical analysis or any other method of trying to make profitable investments in the stock market, in the last part of this work there are some curiosities about it. The balance sheet is divided into two columns: Assets and Liabilities.
Let's imagine a company that is going to be established. Its promoters estimate that with 10,000,000 it can be trained. The owners of the company put 7 and the remaining three are put by the bank with a loan to be paid in 7 years. We already have the Liability that is made up of Social Capital (or own capital) 7,000,000 and Long-term Creditors (long-term debts, or long-term receivables): 3,000,000. Total liabilities: 10,000,000.
What we do with this money will be the asset: let's put 7,000,000 to acquire the land, buildings and machinery necessary to carry out our business.
This would be the fixed or immobilized assets. The remaining three million will form the account called treasury (available) and we will distribute two in financial entities (bank or savings bank) and we are left with one million in the company's safe: social fund.
This would be current assets. That added to the fixed gives us a total asset of 10,000,000.
From here the activity of the company begins. We buy and sell merchandise and at the end of the year we find two new accounts in liabilities: 1st, that of suppliers or short-term payable (short-term creditors). It is about merchandise that we have bought and we are still pending to pay, and 2º that of losses or benefits. In assets we have two new accounts: the customer or realizable (debtors in which the amount of merchandise sold and still pending collection is reflected (Just as they allow us a few days to pay what we buy (for example with a letter to 3 months), we do the same to those we sell.) We complete the asset with the inventory that are products that we buy and have not yet sold.
Assets and Liabilities will always have the same balance. Daily we have made the accounting entries that reflect the economic activity of the company in the journal. Your opening entry or first entry will coincide with the balance sheet at the beginning of the activity and the last entry or closing entry will be the same as the final entry balance. Meanwhile, each company with which we have had operations has its own account in a new book that we call "major". If at the end of the year we neither owe nor owe you, your account is closed to zero. If, on the other hand, we have something to collect or pay, the account remains open with a debit or creditor balance and is added to the balance, as we saw previously. These accounts correspond to other income or expense accounts that do not refer to the company with which it operates but to the product.
Each type of purchase or sale therefore has its own account and through it we will see, for example, how much we have spent throughout the year on electricity, telephone, gasoline,… and how much we have entered for one or another product. These accounts are not settled when they are paid or collected like the previous ones but they make up the profit and loss balance that also consists of two columns: debit and credit, that is, expenses and income. As in the balance sheet, the total of the two columns also matches, but it is rare that the sum of income matches that of expenses. If things went well, we have sold more than the amount spent, then we have profits that will be just the difference between one column and another. The same happens with losses: it is the amount that was spent more than was entered.We may have income from sales, grants or interest in our favor from accounts in financial institutions.
Expenses can also be for purchases, or for interest or financial expenses (there may also be losses, expenses or extraordinary income, but we will not go into it).
Another expense is taxes, which, like financial expenses, are important when calculating gross profit (income minus expenses), profit before taxes (we would not subtract corporate (profit) tax expenses from income, which is like the Income statement of the company. We can also talk about profits before financial expenses, with which we would already focus on the net profit of the entity, that is, only entries and exits for the activity that we develop outside of taxes or loans that are intrude.
The company's buildings or machines suffer wear and tear: we can think that the machine will have to be replaced after 10 years and the building will last 30 years.
This implies that annually the machine will lose 10% of its value and the building 3%. These expenses are the amortizations that accumulate year after year, subtracting the value of the fixed asset.
II ANALYSIS OF THE BALANCE SHEET:
UTILITY: To obtain a diagnosis of the balance on whether the company offers sufficient guarantees and profitability to the potential investor. It will allow us to evaluate the situation of liquidity, indebtedness, financial independence, equity guarantees against third parties, capitalization, efficiency in the management of your assets and financial balance.
TOOLS TO BE USED: Balance sheets: two or more consecutive at the end of the year or quarterly to independently analyze or compare them.
BALANCE SHEET CHECK: The balance sheet is divided into two columns: that of assets and that of liabilities. In a first step we will check:
- Current assets must be greater than the short-term payable. Current assets are total assets minus fixed assets. The short-term payable is found in the liability made up of the supplier account. If this first requirement is not met, the company has liquidity problems, may not meet its expenses and go to suspension of payments. Own capital (which heads the liability column) must amount to 30 or 50% of the total liability. Being below would imply decapitalization and excessive indebtedness.
FINANCING TABLE: Also known as "State of origin and application of funds" and "State of sources and employment." Two consecutive company balance sheets are required. We will open two columns, the one on the left we will call "application", in it we will write down one by one the increases in assets of the last year with respect to the previous one. We will do the same with the decrease in liabilities and finish the column by noting the losses for the year, if there were any. In the right column that we will call "origin" we will write down the increases in liabilities and the reductions in assets, to end by noting the amortizations and benefits for the year that they had.
In this table we can see where the money has come from (origin) and what has been done with it (application), in which it has been invested and how it has been financed: for example, it is negative to invest in fixed assets (this account would have increased), financing it with short-term debts (this account would also have increased), when the appropriate thing is to use own capital or long-term debts (which in our example would have increased less than the short-term due). The company invests in: fixed assets, current assets, repayment of debts and losses. This is financed with its own capital, debts, profits, amortizations and asset sales.
RATIOS: CONCEPT AND USE: They are the result of dividing two related sections of the balance sheet. Their usefulness is obtained by comparing them with previous ones of the same company, with other companies in their sector or other general ones.
Example: Ratios of the profitability of own capital: it is obtained by dividing the net profit between the own capital. The result can be compared with that of the previous year (we will see if the share that the company draws from its own capital rises or falls), or how it is doing in relation to others in its sector.
ANALYSIS WITH RATIOS:
LIQUIDITY: They indicate the possibility of the company to meet its payments:
LIQUIDITY RATIO: it is the current assets divided by the short-term payable. Its value must be higher than 1. If it is lower it indicates a threat of suspension of payments, if it is much higher it can mean idle current assets and therefore loss of profitability.
TREASURY RATIO: It is calculated with the sum between the realizable and the available, divided by the short-term due. It is analyzed as liquidity, but if the treasury is low, and the liquidity is good (above 1), there is excess stocks and a feasible and available lack: threat of suspension of payments.
AVAILABILITY RATIO: It is calculated by dividing the available by the short-term due. It can be compared with that of other periods, it does not have an ideal result above or below 1 like the previous ones, but its increase or decrease implies a threat to payments or idle assets, respectively.
DEBT: Analyzes the quantity, quality of the debt and the company's ability to bear its burden. (It will be completed with another ratio in the analysis of the profit and loss account)
DEBT RATIO: calculated by dividing the total debts by the total liabilities. Its ideal value is between 0.5 and 0.7. If it is higher, the company has excessive debt and is losing its financial autonomy. If it is lower, the company may have an excess of its own capital.
III ANALYSIS OF THE PROFIT AND LOSS ACCOUNT
UTILITY: It is used to diagnose the evolution of the sales figure, the gross margin and the structure and financing expenses.
TOOLS: To calculate the turnover ratios, we will use combined accounts of the balance sheet and the profit and loss account. For the rest, we will use the latter data.
CHECKING THE PROFIT AND LOSS ACCOUNT: The profit and loss account is divided into two columns called "must" and "have" respectively. They reflect the entries (for sales, for example) and the exits (for purchases). A first step will consist of taking the percentage that each account represents from the total of your column and comparing it with previous periods: we will be able to see if sales have decreased, we will find ourselves with the paradox that perhaps profits are increasing despite an alarming drop in sales, simply because costs have been reduced (for example, interest on loans by lowering interest rates), see if this happens in other companies in the sector and deduce if this will lead to a loss of competitiveness and market, etc.
ANALYSIS WITH RATIOS:
DEBT: To see if the company can bear the debt it has. It is calculated by dividing financial expenses by sales. If the result exceeds 0.05, the financial expenses are excessive. Between 0.04 and 0.05: caution. Less indicates that the financial expenses are not excessive in relation to the sales figure. An example of financial expenses is interest on loans.
ASSET ROTATION: It allows studying the yield obtained from the assets, which, although they are on the balance sheet, are calculated using the sales that belong to the profit and loss account. The higher the result, the better.
ROTATION RATIO OF FIXED ASSETS: obtained by dividing sales by fixed assets. The higher the result, the more sales are generated with the fixed asset.
CURRENT ASSETS TURNOVER RATIO: It is calculated by dividing sales by current assets.
STOCK TURNOVER RATIO: It is calculated dividing sales by stocks. If sales are taken at cost price, all the better, since stocks are taken at that price.
Conclusion: we will analyze these ratios for years and it is advisable for them to increase as this will make it less and less necessary to invest in the asset and the company will be more efficient.
DEADLINE RATIOS: They serve to check the evolution of the collection and payment policy to customers and suppliers respectively.
COLLECTION PERIOD RATIO: Indicates the average number of days it takes to charge customers: it is calculated by multiplying the result of the following division by 365: the sum of customers plus bills to collect plus discounted bills pending expiration, divided by sales. The lower it is, the earlier customers are charged.
PAYMENT TERM RATIO: It is calculated by multiplying the result of dividing suppliers by purchases by 365. The higher it is, the longer it takes to pay. The delay in payment may be by prior agreement with the providers.
SALES EXPANSION RATIO It is calculated by dividing the sales of one year by those of the previous year. The bigger the better. It is convenient to take into account the inflation of the year, if it is a very sensitive sector to inflation. Example: if inflation is 5%, for sales to grow the result must be greater than 1.05%.
MARKET SHARE RATIO: calculated by dividing the company's sales figure by the sales figure of the sector to which it belongs. This data does not belong to any balance sheet of the company studied and is obtained by adding all the sales figures of the companies in the sector, in the same period.
PARTICIPATION RATIO OF EACH PRODUCT IN TOTAL SALES: It is calculated for each product of the company by dividing the sales of product "x" by the total sales of the company.
IV ANALYSIS OF PROFITABILITY:
YIELD: It is the profit obtained before paying interest and taxes, divided by the total assets. The higher the better: you get more productivity from the asset.
FINANCIAL PROFITABILITY: It is calculated dividing the net profit between the own capital. It measures the net profit generated in relation to the investment of the owners of the company. The result must at least be positive and the higher it is: the higher the profitability. It can also be calculated from the decomposition into three ratios as follows: profitability will be equal to dividing net profit by sales, this gives us the margin; divide the sales by the total assets that will give us the turnover and divide the total assets between the equity capital that will give us the leverage. We will finally obtain profitability by multiplying margin by turnover by leverage.
According to this, the company will increase its profitability:
Increasing the margin: raising prices, reducing expenses, or both.
Increasing turnover: selling more, reducing the asset, or both.
Increasing leverage: increasing debt so that the ratio between assets and equity is higher. This seems a contradiction but it is as bad to have an excess of debt as a decompensation of this with your own capital.
FINANCIAL LEVERAGE: If the leverage is obtained by dividing the assets by the equity, the financial leverage is calculated by dividing the profit before taxes between the profit before interest and taxes and multiplying the result by the leverage.
Relate the debt with the financial expenses it causes. For its ratio to be favorable, the result must be greater than 1. It is positive when the use of debt allows increasing the profitability of the company. As the debt increases, the proportion of equity capital decreases and therefore the financial profitability ratio that we studied at the beginning will grow if equity capital decreases more than the net profit at which they divide. Let me explain, we said at the beginning that profitability was equal to net profit divided by own capital; If by increasing the external capital, the financial expenses they generate do not prevent the net profit from growing, and while, the equity capital has not decreased or they have done so to a lesser extent than the net profit,the result of the division will be higher and therefore the profitability ratio will have increased.
When the financial leverage ratio is greater than 1, debt increases profitability and it is therefore convenient, when it is 1, it does not alter profitability and when it is less than 1, profitability decreases.
CONCLUSION: Leverage depends on the profit before interest and taxes and the cost and volume of debt, so the use of debt is not always positive.
SELF-FINANCING:
CONCEPT: Resources invested in the company, generated by itself.
SELF-FINANCING CAPACITY: Also called cash flow, it is the sum of net profit plus amortizations.
SELF-FINANCING RATIO GENERATED ON SALES: It is the cash flow (net profit + amortization), divided by sales. The larger it is, the more funds the company will be generating from sales.
SELF-FINANCING RATIO GENERATED ON ASSETS: it is the result of dividing the cash flow by the total assets. The bigger the better.
SELF-FINANCING POLICY RATIO: It is calculated by dividing dividends by cash flow. The higher the ratio, the less self-financing.
DIVIDEND POLICY RATIO: calculated by dividing dividends by net profit. The higher the ratio, the lower the self-financing.
V THE ACTION: VALUE AND RATIOS
VALUE OF A SHARE: It serves to estimate the price that can be paid or at which a share can be sold. It is calculated in different ways
ACCOUNTING VALUES OF A SHARE:
- Own capital divided by the number of shares Total assets less debts, divided by the number of shares
ACCOUNTING VALUE OF A COMPANY:
- Own capital Assets less debts
REAL VALUE OF A SHARE:
The book value is usually fictitious because it is based on purchase prices.
The real value is calculated by subtracting the debts from the real value of the asset and dividing the result by the number of shares.
The real value of the asset (called intrinsic value) consists of what the market would be willing to pay for it. If it is made up of assets that increase in value over time (land), the actual value may exceed the book value.
The market value of a share is the one that reflects its price on the stock market.
Future value of a share: it is calculated by obtaining the value of all the benefits expected from the share in the future.
RATIOS:
PROFIT PER SHARE: To evaluate the returns obtained from a share, it is calculated by dividing the net profit by the number of shares.
DIVIDEND PER SHARE: It is the total dividend distributed divided by the number of shares. Gross: If you include the taxes that the company withholds. Net if they have already been deducted.
PROFITABILITY PER DIVIDEND:
ON ACCOUNTING VALUE: It is the dividend per share divided by the book value of the share.
ABOUT THE MARKET VALUE: It is the dividend per share divided by the market value per share.
ON THE NOMINAL VALUE: It is the dividend per share divided by the nominal value of the share.
CASH FLOW PER SHARE: It is a reflection of the funds generated by a company per share. It is the sum of the net profit plus the amortizations divided by the number of shares. The higher its value, the better the returns and expectations a stock offers.
PAY OUT (DIVIDEND POLICY RATIO): It is the dividend per share divided by the earnings per share. It is an indicator of the company's self-financing and dividend distribution policy. Ideally, the shareholder receives a significant dividend as long as the company continues to be properly self-financing.
THE QUOTE, RATIOS:
PER: (From English: Price Earnings Ratio). It is calculated by dividing the share price by the earnings per share. If it is very high, it indicates that the stock is possibly overvalued, the market is paying too much for each peseta of profit that the company obtains. The value 7 is usually considered ideal, neither high nor low.
CASH FLOW MULTIPLIER: It is calculated dividing the share price by the cash flow per share. It is similar to the PER, and the lower it is, the cheaper the stock.
OF THE ACCOUNTING VALUE OF THE SHARE: We will obtain it by dividing the quotation by the book value of the share. If it is greater than 1, you pay more than its book value.
OF THE REAL VALUE OF THE SHARE: It is calculated dividing the price of the share by the real value of the share.
CONCLUSION: A share will be cheap when the PER is 7 or less, or lower than the average of the other shares in the same sector and the price is not much higher than its book value. If the earnings per share, the cash flow per share, the dividend per share and its book value also grow, we are undoubtedly facing an interesting action.
VI EPILOGUE: Other alternatives to financial analysis:
- Skirt indicator theory: When the miniskirt becomes fashionable, we live an upward cycle; the opposite occurs when long skirts are worn. Rationale: The miniskirt is associated with optimism. Formerly, in times of famine, women were killed so that they would not procreate and in times of abundance their charms were highlighted so that the offspring would increase. The skirt indicator theory is a kind of unconscious reminiscence of these practices Investor Profile Theory: When we do not know what proportion of our savings to dedicate to the stock market, we only have to subtract our age from 100: An investor of 30 years would allocate 70%: 100-30 = 70. Background: It is more appropriate to assume the risk when we are generating our savings. Theory of the opposing opinion, in English: ODD-LOT Theory:Assuming that the small investor is always wrong, it is a matter of observing what operations we small investors do, to do just the opposite. It is achieved by obtaining the data of purchases or sales of small lots of 100 titles or less. From now on, I plan to make the right bets to annoy those who follow this theory.
