Health of the company through balance sheet

POSTED BY Ravikumar Suganandam ON September 25, 2010 6:23 am COMMENTS (9)

How to determine the health of the company with the help of balance sheet? Apart from Net profit growth/sales growth etc, what are all the key factors to be looked into? What are all the ususal tricks which company would play to hide their disadvantages?

If someone throws light on the above points, it would be added benefit for all the budding investors.

9 replies on this article “Health of the company through balance sheet”

  1. Jagadees says:

    @Ravi,
    In simple terms, a company’s book value tells you how much money would be left for shareholders after selling all its assets and pay off all its liabilities at the particular point of time.

    Book value = (Total assets-Intangible assets) – Total liabilities

    1. Subtract the reported value of the company’s intangible assets from the value of the company’s total assets. Intangible assets are things like trademarks and patents, which are difficult to value. The valuation of intangible assets is highly subjective, so just exclude them from your calculation.
    2. Then Subtract the value of the company’s total liabilities from the value of the company’s total assets less intangible assets. The resulting figure is the company’s book value

    Hope it will clears ur doubt 🙂

    1. Jagdees, Thanks for your kind response.

  2. Jagadees says:

    @ravi,you can directly look book value per share in company’s annual report. sometimes company will have consolidated five/ten years review will be there in the annual report. there you can see whether book value per share increases consistently year after year.

    Hope it will help.

    1. Jagdees, my Q is how book value is being calculated?

  3. Thanks Jagdees, that is a nice explanation, you have hit the bulls eye. Can you also pl let me know how book value is calculated?

  4. Vikas Sharma says:

    There are loads of things to be checked. There’s no golden rule / principle because there are other soft comforts like promoters repute (TATA), Industry, legacy in business etc.

    Generally, see that his debt should not be more than 40%-50% of his sales. Upto 30% is ok.

    High debt is not very high than its TNW (Share cap + Free Reserves). Upto 2x or 2.5x is ok.

    LC’s o/s are treated as contingent items but these should be added to debt for a trading kind of entity has no debt on its books but has huge LC’s o/s.

    See industry reports freely available on many website and lastly, share his financials on jagoinvestors and we’ll help us decide. Cheers!!!

  5. Jagadees says:

    oops, the formula for return on total capital in above response is distorted. here is the clear one:
    Return on Total capital (in %) = (Net Profit + Interest Charges) X 100/ (Equity capital + Debt capital)

  6. Jagadees says:

    I think following parameters will help to judge financial health of the company:

    1. Return on Total capital
    2. Earnings per share
    3. Net sales
    4. Debt ratio

    1. Return on total capital (ROTC):
    I would say this is the single most important ratio to judge the financial health of the company. some may call this as “God ratio in finance”. Return on total Capital is a measure of the return generated by the company on the investments it has made in the business.
    (Net Profit + Interest Charges)
    Return on Total capital (in %) = —————————————— X 100
    (Equity capital + Debt capital)
    It gives us a better picture of the returns because it includes return on investment made from all sources – both debt and equity. Companies that ‘consistently’ achieve a high return-on-capital(>20%) can be considered to be ‘fitter’, as they are likely to have long-term advantages of some kind.
    But on the other hand Return of equity (ROE), the most common but useless ratio used in TV channels will not include the debt capital and hence present rosier picture of a highly leverage ordinary company.

    2. Earnings per share:
    Earnings per share give us the profitability per share figure.
    Earnings Per Share (EPS) = Profit After Tax / Total number of equity shares issued
    Net profit usually referred to as bottomline of the company. It should grow year after year consistently for a good company. We need to look for a company with consistently growing EPS usually >12%.

    3. Net sales:
    A company can continue to be profitable only when the sales are increasing. So we want to check whether the net sales figure of the company consistently growing @ >12%.usually in market they will refer as Topline of the company.

    4. Debt ratio:
    Debt capital divided by total capital should be less than 25%. This is more important because a highly leverage company (i.e. company with more debt) whose going will be happy in good economic conditions but will struggle in the adverse economic conditions like 2008 US credit crisis due to heavy debt burden.

    Besides we can also can look @ whether the book value per share is increasing consistently.

    Note: For all the above parameters we need to look at the company for a minimum 6 years period (if possible 10 years) to judge the financial health.

    For further reading on Return on total capital, you can visit this site – http://www.shyamscolumn.com/2009/04/god-ratio-in-finance.html

    Happy investing 🙂

    1. Ram says:

      Jagadees,

      Great stuff. Just a note, if you take 1 and 4 together, you can replace 1 by ROE because you’re already doing a health-check on debt in 4.

      Regards,
      Ram.

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