To understand and value a company, investors have to look at its financial position. Fortunately, it is not as difficult as it sounds to perform a financial analysis of a company by examining its financial statements.
If you borrow money from a bank, you have to list the value of all of your significant assets, as well as all of 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 appropriately 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 that financial position in relation to market value. Let's take a look.
Start with the Balance Sheet
Like your financial position, a company's financial situation is defined by its assets and liabilities. A company's financial position also includes shareholder equity. All of this information is presented to shareholders in the balance sheet.
Let's suppose that we are examining the financial statements of the fictitious publicly listed retailer The Outlet to evaluate its financial position. To do this, we review 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.
Current Assets and Liabilities
Assets and liabilities are broken into current and non-current items. Current assets or current liabilities are those with an expected life of fewer than 12 months. For example, suppose that the inventories that The Outlet reported as of December 31, 2018, are expected to be sold within the following year, at which point the level of inventory will fall, and the amount of cash will rise.
Like most other retailers, The Outlet's inventory represents a significant 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 a stock 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.
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.
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 any profit not paid to shareholders as a dividend.
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 crucial tool for value investors. 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 financial analysis of a company's financial statements - along with the footnotes in the annual report - is essential for any serious investor wanting to understand and value a company properly.