Revisit: Making sense of Balance Sheet & Cashflow

[First published on 25/03/2016]

This is very important stuff for making sense of the annual reports and I have summarized them below in simple terms for my future lazy brain.



Making sense of a company's Balance sheet - 
it should all balance up


In a Balance sheet there's two parts of equivalent values:

1) Total Assets $ =
2) Total liabilities and Equity

This is because Equity = Total assets - Total liabilities, so both values would be the same.

Equity is also known as net asset or net worth of a company. It comprises of two parts - Retained earnings (accumulative net income) and Treasury stocks


An important ratio which you can derive from the balance sheet data is the current ratio. It is calculated as follow:

Current Assets / Current Liabilities

If it is more than 1.5, the company is generally doing okay (its assets are able to cover for its debts).


Statement of Cash flow - 
show me the money $


show cash
Credit: Sabine Peters on Unsplash

Cash flow is important because it tells you how much cash a company generates and the in/out as the term suggests.
If a company makes profit but did not generate any spare cash in the process, it might spell financial trouble ahead.

The Cash flow statement (CFS) has three parts to it:

1) Operating activiities

2) Investing activities


3) Financing activities




Free Cash Flow = Cash from Operations - Capital Expenditures


(Above is the general formula. However, there may be more than one way to calculate free cash flow. Refer to this post.)


Note that Cash Flow Statement is distinct from the Income Statement and Balance Sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which on the income statement and balance sheet, includes cash sales and sales made on credit, as well as assets depreciation.


From a book which I borrowed. Can't recall the book's title.


Sometimes you will come across this term called "working capital". Working capital represents the difference between a firm’s current assets and current liabilities (current means short-term eg within 1 year). Something like a subset of Equity.
Read about it- https://www.investopedia.com/ask/answers/071114/how-do-changes-working-capital-affect-companys-cash-flow.asp]

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Just bear in mind that sometimes things are not as simple as they look because there is such a thing call 'financial engineering' where some figures could be created to make things look good and yet legit. For example, manipulation of ROE through aggressive stock buybacks despite in high debt, no re-evaluation of company's fixed asset etc.

Also look out for any third-party related transactions and look out for exceptionally big figure of good wills. These would require more in-depth reading for a good understanding.

***

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Comments

  1. Think deeper on retained earning and understand more. Seldom mentioned by investment writers.

    ReplyDelete
  2. Hi Uncle8888,

    "By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. It is also called earnings surplus and represents the reserve money, which is available to the company management for reinvesting back into the business. When expressed as a percentage of total earnings, it is also called retention ratio and is equal to (1 - dividend payout ratio)." Source: https://www.investopedia.com/terms/r/retainedearnings.asp


    Growth companies may have high retained earnings, whereas mature companies may have lower retained earning (if they have no better place to use the money). To delve deeper on HOW companies use their retained earnings, I guess we can't just see the SGX company datasheet but got to plow through the annual reports?

    ReplyDelete
  3. Hi,
    I am a newbie and hope you can advise on the following:
    1. Under cash flow, a negative number means using cash will provide value to shareholders. Could you elaborate a bit more? How will shareholder gain value? Through dividends?
    2. How will stock buy back improve ROE? Wont the net income be lower as a result of buying back the shares albeit outstanding shares will be less?

    ReplyDelete
    Replies
    1. Hi Patrol,

      1. If a negative figure appears under cashflow financing activities, you are right, it could be due to dividend payout. Read more https://www.investopedia.com/articles/investing/120613/cash-flow-statement-analyzing-cash-flow-financing-activities.asp

      2. ROE is dependent on Net Income. The money used for share buyback comes from the company's asset / surplus funds, not its net income.
      Read also:
      https://finance.zacks.com/treasury-stock-affect-retained-earnings-7654.html
      https://rainbowcoin.blogspot.com/2018/09/share-buyback-what-it-means-and.html

      Hope you get a clearer picture now.

      Delete

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