Balance Sheet: What to look out for?

About
This short article is for people who are new to investing and want to know the simple basics of look out for a healthy company, in which a simple glance at the balance sheet is all it takes to determine whether a company is worth while or not.

What is assets,liabilities and Shareholder's Equity?
Lets say you have a friend who recently opened a small shop, selling chicken rice in a hawker centre. His parents supports him by giving him $5000 and he also took up a loan from the bank say about $10,000. After that, he used the money and started buying raw chickens from a supplier and all other equipment and ingredients such as Knife, chopping block,cooker,rice, sesame oil, pepper,MSG etc necessary for making the chicken rice.

So based on this simple story, what are considered as assets?

Its simply the small stall you own, the amount of cash left over and of course the chickens and all the nessary items he bought.

As for liabilities it is the $10,000 he loaned from the bank.
But how about the $5,000 his parents gave to him ? That would then be classified under Shareholder's Equity in short (SE)

So going back to the story, fast forward into the futre, you realise that your friend's business is doing well. And you want to have a profit in it. Thus you come to him one day and say, hi i would like to invest in your chicken rice, but before i do that, can you write down on paper the status of your stall?

Your friend wrote down on a piece of paper and passes it to you. That piece of paper is therefore called a balance sheet, a review of what your friend's owns and what he owes. (Of course before investing in any business, you have to also look out for another things like industry outlook, Profit and loss etc)

So in what case would you invest in your friend's chicken rice stall: Is it

case 1: The amount of chickens increased tremendously, his cook instruments stay the same and he took an extra $20,000 loan from the bank.

case 2: The amount of cash increased, the amount of chickens and ingredients are dropping , his loan amount remain the same and his other friends also supported him by giving him more money.

Common sense would have made you choose the latter case, simply because, if it was case 1, then your friend might have problems refinancing the loan back to the bank right? Thus, this is a simple illustration on what to look out for a in balance sheet.

But , coming back to the real world, no balance sheet is that simple, most of the time companies balance sheets can be quite complicated and have to read a lot before you fully understand it's health and durability.

Steps
But fret not, i created 6 simple steps to determine what makes a healthy company balance sheet.

Step 1: Look out for cash balances under current assets. Look at the cash figure and compare it with current liabilities. You want to see more cash then current liabilities in this case. (Solvency)
If there is not enough cash, to cover up current liabilities, then you have to be careful already. Ask yourself, can the receivables and inventories cover up the left over current liabilities if you were to discount them by a Conservative 50%?

Therefore a healthy balance sheet is one with enough cash to cover up its current liabilities.

Step2: Look at long term liabilities, then simply go to the profit and loss account. Take that figures and divide it by the long term liabilities. Etc:

Total Net profit: $10,000

Total Long term liabilities: $30,000

Result: 3 times.

If you calculated the figure to be more then 4 times, beware.

Any where from 3 and below it's fine.

Step 3: Look at the company's inventories and trade receivable under the current asset Coulomb. Then see if the previous years , whether both these accounts have they increased tremendously ? Or have they increase in accordance to sales?

If any of these accounts "Inventories" and "Trade receivable" increase more then 150-200% be careful, ask the investor relationship manager (IRM) why? What good reason is there for such an increase? Because...

-Too much inventories = More cost =over produced = Less profit in the future

-Too much receivables = Too lenient = Less cash flow = More bad debts

Step 4: Look at the company past years' long term assets like properties , plants, equipment. Is it increasing? Ask yourself why is it increasing, did the management promise some expansion in last year's annual report? Is it increasing too fast? That might lead to over expansion, if this is the case, then you must judge for yourself is the company's industry doing well also , in order to support the supply of the company's products.

If its decreasing, also ask why? They did sell off any of their assets therefore resulting in a huge increase in their profit and loss?

In general a steady growth of plants, equipment, properties in accordings to sales figure is a positive feature of a healthy balance sheet.

Step 5: Look out for accounts like Goodwill and Deferred Tax (Under assets), these are not considered proper assets and should be discounted fully to be conservative when calculating NAV ps which then brings me to my next and final step

Step 6: Calculating NAV ps. Simply by taking total assets - total Liabilities, once you get the figure, divide it by the no. of shares found in the shareholding statement. That figure you get, its called (NAV ps) Net asset value per share. NAV ps is simply a figure that tells you what is left over in the company and what can be distributed to Shareholders should the company delist or get wiped out.

Therefore it is very important to calculate this figure ,as you will be able to estimate downside risk and upside growth.

Best to invest in companies that trades below its NAV ps, in which this current crisis is presenting these opportunities to do so.

Sooner or later, the market will have to come back to its senses and offer these shares at or above their NAV ps.

Give away tips
Shares that i know that are trading way below their NAV ps are

1)Sino Tech (Abundant in Equipment and properties )

2)Wheelock properties (Cash Rich)

3)China Milk (Cash Rich)

4)China Essence (Abundant in Equipment and properties)

5)Golden Agri

6)ASL Marine
7)Aus Group

Lastly, for savy investors, they usually discount the NAV ps by discounting some inventories, some receivables in accordance to their judgement and definition of whats being conservative.

For further reading i suggest this book by: George T. Friedlob, Franklin J., Jr. Plewa

Once again, stay vested and happy investing :)