To that regard, balance sheet analysis is something that often goes ignored, especially, when you are looking at stocks but its something that is perhaps the central driving force of understanding what makes a company tick.
Nikhil Vora, MD of IDFC Securities and Bharat Iyer, Head-India Equity Research at JPMorgan, in an interview with CNBC-TV18's Mitali Mukherjee break up the workings of a balance sheet and explain how it should be analyzed.
Below is a verbatim transcript. For the complete details watch the accompanying video.
Q: How would you define what a balance sheet is and what its analysis entails?
Vora: The genesis or the core of any investment research lies in how one is able to understand and analyze balance sheets and make a slightly more informed decision making post that. Its important to read the numbers beyond what is published, be it on the revenue growth of businesses and how that's getting derived, to what are the salience's of certain balance sheet items, be it on the debt part, be it on receivables and so on.
It's important to judge particular businesses and companies in the context of how their reporting standards are and how transparent and consistent they are in the same as we move forward.
Q: For a lot of people who analyze stocks it is a non-sexy item in terms of analyzing the company, it's easier to work with earnings or ratios rather than read some kind of conclusion?
Iyer: I guess while earnings is just one particular number what you want to see is the key drivers and the key pressure points behind the number and it's very important to look out for these. Reporting a set of numbers given some constraints is always easy but from an analyst perspective we want to see what is driving numbers and what is impacting numbers.
For that you need better disclosures and you want to see the background information behind it. Luckily in India, we have fairly well set accounting standards. Earnings are reported almost four times a year every quarter and we also have access to balance sheet and cash flow data at least once in a year. So while you prefer balance sheet and cash flow data more often, I guess even the earnings numbers given to us once a quarter are fairly well defined and we have fairly decent disclosure standards so that does help.
Q: To get to the broad heads of a balance sheet that we are looking at, there is assets liabilities, equity of cost but let's take it with assets. What are the ABC items you would look at while analyzing the asset side of a company?
Vora: I think the most critical element of any balance sheet read that one would look at is to look at the size of the balance sheet first level and its important from the construe that one makes about growth of a business whether the balance sheet size also keeps growing in pace with that because the revenue generation capability of any business is dependent on the investments or the asset base that the company has over a period of time and how they build it up.
The first level is to look at how the overall fixed asset of the business mold grows and the second part is to look at the constituent of that fixed asset and how that is getting financed out, be it through the net worth of the company or through the debt of the business. To me that's the two critical elements to look out for.
The third part is to look at the receivables in that business because as we move forward whether the business growth is been driven by the underlying cash flow generation capability of the company or it's been funded by pushing the business through a receivable cycle which can literally lead to debt trap over a period of time that's the critical element to look at.
Q: Aside from the size of a balance sheet does the structure and style of the business matters as well because on your point about cash flows, it makes something like a construction company more vulnerable versus another sector, right?
Vora: It does. That's the reason why you also see in lot of cases how businesses tend to get de-rated or rerated based on how the balance sheet is perceived to move today and forward. A business which has the capability to grow on its own cash flow which would mean that its generating adequate cash reserves and thereby growing on net worth and not on debt does tend to get rerated significantly ahead rather than a business which is growing on external capital at every stage in their growth path.
That's the difference which ideally gets realized very early in life. You start to look at businesses accordingly and the fact that they are a branded business for instance will grow significantly on their own cash generation whereas in a lot of infra businesses that we look at today, it does grow on external capital. Thereby the rerates in those businesses do take a lot more time and a lot more persistence than a branded business or a consumer business would do.
Q: What do you watch for while analyzing the balance sheet for company in order to understand the liabilities what do you watch for while analyzing the balance sheet of a company in order to understand the liabilities and more importantly the size of them and the impact on earnings thereof?
Iyer: When you are looking at the liabilities, you look at quite a few factors. It's just not the quantum of liabilities; you are looking at the solvency of the company itself whether the sheer size of the liability in relation to the size of the company's operations. You are also looking at the liquidity situation of the company.
You are looking at the tenure of the debt in particular because what you don't want as a mismatch between the borrowing side and the asset side, you don't what long-term borrowings going into short-term assets or visa versa.
Besides this, you also look at few factors like the nature of balance sheet items, if the company has indulged in sale and leaseback for example or even the contingent liabilities they tend to be very important because these are very easy to ignore but they do have a material impact on the company's operations down the line. It's quite important to take at comprehensive view.
Q: Why is it that a lot of people also tend to work with cash flow statement rather than the balance sheet and what would you draw as a defining line between the two?
Vora: At lot of points in time, balance sheets are a statement of intent which the business does over a period of time because a lot of times you do tend to capitalize the business ahead of time and thereby the impacts on cash flows are not as significant in the near-term as it ought to be. Hence, the return ratios or return on capital does tend to look significantly lower than adequate or fair return on capital of those businesses.
Cash flows are more dependent on the profitability or the underlying business merit as of that moment. The near-term visibility of a business is determined by the cash flow generation capability of a business whereas the longer-term longevity of a business would possibly be driven by how the balance sheet structure is and how capitalization moves.
Both of them are not independent factors. It's interdependent. I would think that cash flows are something which I would be comfortable if I had to look at the next two-three years of business growth and how the underlying businesses are. Balance sheet would be more dependent about the amount of capitalization and the amount of growth needs for a business and thereby the longevity of a business over a period of time.
No comments:
Post a Comment