To understand and value a company, investor have to look at its financial position. Fortunately, this is not as difficult as it sounds.

If you borrow money from a bank, you have to list the value of all your significant assets, as well as all your significant liabilities. Your bank uses this information to assess the strength of your financial position; it looks at the quality of the assets, such as your car and your house, and places a conservative valuation upon them. The bank also ensures that all liabilities, such as mortgage and credit card debt, are properly disclosed and fully valued. The total value of all assets less the total value of all liabilities gives your net worth, or equity.

Evaluating the financial position of a listed company is quite similar, except investors need to take another step and consider financial position in relation to market value. Let's take a look.

Tutorial: Introduction To Fundamental Analysis

Start With the Balance Sheet
Like your own financial position, a company's financial position is defined by its assets and liabilities. A company's financial position also includes shareholder equity. All this information is presented to shareholders in the balance sheet.

Let's suppose that we are examining the financial statements of fictitious publicly listed retailer, The Outlet, to evaluate its financial position. To do this, we examine the company's annual report, which can often be downloaded from a company's website. The standard format for the balance sheet is assets, followed by liabilities, then shareholder equity. (For more on the balance sheet, see the article Reading the Balance Sheet.)

Current Assets and Liabilities
Assets and liabilities are broken into current and non-current items. Current assets or liabilities are those with an expected life of less than 12 months. For example, suppose that the inventories that The Outlet reported as of January 31, 2010, are expected to be sold within the following year, whereupon the level of inventory will fall and the amount of cash will rise.

Like most other retailers, The Outlet's inventory represents a big proportion of its current assets, and so should be carefully examined. Since inventory requires a real investment of precious capital, companies will try to minimize the value of inventory for a given level of sales, or maximize the level of sales for a given level of inventory. So, if The Outlet sees a 20% fall in inventory value together with a 23% jump in sales over the prior year, this is a sign they are managing their inventory relatively well. This reduction makes a positive contribution to the company's operating cash flows.

Current liabilities are the obligations the company has to pay within the coming year, and include existing (or accrued) obligations to suppliers, employees, the tax office and providers of short-term finance. Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due.

The Current Ratio
The current ratio - which is total current assets divided by total current liabilities - is commonly used by analysts to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables or inventory. Like any form of ratio analysis, the evaluation of a company's current ratio should take place in relation to the past. (To learn more, read Dynamic Current Ratio: What It Is And How To Use It.)

Non-Current Assets and Liabilities
Non-current assets or liabilities are those with lives expected to extend beyond the next year. For a company like The Outlet, its biggest non-current asset is likely to be the property, plant and equipment the company needs to run its business.

Long-term liabilities might be related to obligations under property, plant and equipment leasing contracts, along with other borrowings. (Learn more about analyzing long-term liabilities in Financial Statements: Long-Term Liabilities.)

Financial Position: Book Value
If we subtract total liabilities from assets, we are left with shareholder equity. Essentially, this is the book value, or accounting value, of the shareholders' stake in the company. It is principally made up of the capital contributed by shareholders over time and profits earned and retained by the company, including that portion of the any profit not paid to shareholders as a dividend. (Learn more about book value and what it means to investors in Book Value: How Reliable Is It To Investors?)

Market-to-Book Multiple
By comparing the company's market value to its book value, investors can in part determine whether a stock is under- or over-priced. The market-to-book multiple, while it does have shortcomings, remains a key tool for value investors. (You can read more about the market-to-book multiple in the article Value by the Book.) Extensive academic evidence shows that companies with low market-to-book stocks perform better than those with high multiples. This makes sense since a low market-to-book multiple shows that the company has a strong financial position in relation to its price tag.

Determining what can be defined as a high or low market-to-book ratio also depends on comparisons. To get a sense of whether The Outlet's book-to-market multiple is high or low, you need to compare it to the multiples of other publicly listed retailers.

The Bottom Line
A company's financial position tells investors about its general well-being. A study of it (and the footnotes in the annual report) is essential for any serious investor wanting to understand and value a company properly.

Related Articles
  1. Stock Analysis

    4 Reasons Intercept Pharmaceuticals Should Be on Your Radar

    Learn about Intercept Pharmaceuticals and what type of biopharmaceuticals it seeks to create. Understand four reasons why the company is a good investment.
  2. Economics

    Explaining Appreciation

    Appreciation refers to an increase over time in the value of an investment or asset.
  3. Investing Basics

    5 Ways to Double Your Investment

    So if you want to go double, consider these five classic strategies to help turn your vision into a reality.
  4. Economics

    Calculating Long-Term Debt to Total Assets Ratio

    A company’s long-term debt to total assets ratio shows the percentage of its assets that are financed with long-term debt.
  5. Investing

    How Worried Should We Be About China?

    An economic slowdown, a freezing up in trade and plunging markets and currencies are casting a shadow across Asia—and the globe. How worried should we be?
  6. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  7. Investing

    How ETFs May Save You Thousands

    Being vigilant about the amount you pay and what you get for is important, but adding ETFs into the investment mix fits well with a value-seeking nature.
  8. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  9. Stock Analysis

    What Seagate Gains by Acquiring Dot Hill Systems

    Examine the Seagate acquisition of Dot Hill Systems, and learn what Seagate is looking to gain by acquiring Dot Hill's software technology.
  10. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  1. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  2. Can working capital be negative?

    Working capital can be negative if a company's current assets are less than its current liabilities. Working capital is calculated ... Read Full Answer >>
  3. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  4. Does working capital include prepaid expenses?

    The calculation for working capital includes any prepaid expenses that are due within one year, since such prepaid expenses ... Read Full Answer >>
  5. Does working capital include short-term debt?

    Short-term debt is considered part of a company's current liabilities and is included in the calculation of working capital. ... Read Full Answer >>
  6. Do dividends affect working capital?

    Regardless of whether cash dividends are paid or accrued, a company's working capital is reduced. When cash dividends are ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!