There is a lot of information in a balance sheet. However, given that this article is angled at beginners in investing, the basics rather than the advanced will be discussed here. The balance sheet is a snapshot of a company’s assets and liabilities, at a particular date.
In general, assets are valuable property while liabilities are what is owed. Whatever that is of value minus what is owed is the equity value or the book value in accounting terms.
An example may shed some light on this matter.
Terry has $1 million in his bank account, a $2 million property by the beach and $1 million in debt. That is all he has. Now his assets is composed of the $1 million in cash and the $2 million property. Adding that up, the total assets that Terry possesses is $3 million. Now is that all there is to it?
No not really. One could go down the rabbit hole and end up some place deep. Undoubtedly that would add to the investor’s repertoire of skills: the ability to interpret the balance sheet of a company.
Now, if the investor were to pay off his $1 million in debt using his cash, he would only have the property left. That property is worth $2 million. That is the value of his equity. Or that is simply his net worth.
In value investing terms, if the equity value of a company is growing and the company’s share price or market capitalisation is below that of the equity value, one may consider the company a possible candidate for investing. This is the essence of the low price to book strategy. With certain conditions met, the low price to book strategy is a sound one and will do well over time.
Growing Book Value
A growing book value paints a picture of an improving financial health. So typically, if an investor combines a low price to book strategy with operating conditions that produce positive operating cash flow and profitability, what investors get is a low price to assets combined with a balance sheet that keeps growing with cash. That growth in balance sheet shows up as an increase in net tangible assets and this is a good thing.
Now let us look a Paul.
Poor Paul has $10 million in assets but $15 million in debt. Despite his large value of assets, this debt is greater than the value of assets. Hence, his equity is negative $5 million!
Given a choice, who would you like to be? Paul or Terry. Looking at it from a balance sheet perspective, one would have preferred Terry. But there are instances where a company could be highly cash generative in the near future which would make Paul a better option relatively speaking.
An Investor’s Balance Sheet
When it comes to value investing, we have that same focus. And focus is on buying undervalued securities. These undervalued securities have a baked in margin of safety that make up the part of the assets or portfolio of a value investor. Over time, these assets grow in value. As the value of the assets grow, assuming that the liabilities have not grown, a person’s net worth will grow as the assets grow over time. That person’s net worth is also by the way the equivalent of the book value in accounting terms. Corporate balance sheets are very much the same thing as a personal balance sheet. These items on the balance sheet can be further divided in current assets, non-current assets, current liabilities and non-current liabilities.
Corporate Balance Sheets
Corporate balance sheets are very much the same thing as a personal balance sheet. These items on the balance sheet can be further divided in current assets, non-current assets, current liabilities and non-current liabilities.Current assets are assets that be converted to cash within a short time span of 12 months. Current liabilities is what is owed by a company to creditors over the next 12 months. Non-current assets are typically investments made by the company that are not as easily converted to cash as the current assets. They comprise of plant, property and equipment and any assets which are deemed to have a long term value. And then, last but not least, we have non-current liabilities which represent liabilities which are owed to creditors and will come due in 12 months or more.
Thanks for reading! As always, may you be blessed with prosperity, health and happiness!.
These books which I have written are case study driven and discuss strategies, mindsets and situational approaches to employing the net current asset value strategy.
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