In this blog post, we will analyse the balance sheet and talk a bit about ratios like P/E and P/B. It’s super important that you understand the red line between equity, debt, and dividends (I’ll write the Norwegian terminology in brackets), and this blog post will teach you exactly that!
The investment side of the balance sheet
A company’s balance sheet can be divided into two parts, the investment part and the financial part. On the left side, you will find two sections: Fixed assets (anleggsmidler) and Current assets (omløpsmidler). Let´s dig deeper:
- Fixed assets:
Here you will find the following:
A. Intangible assets (immaterie eiendeler) ->
examples: sales-and production rights.
B. Tangible assets (materielle eidendeler)
examples: rental apartments, ships, machines…
- Financial fixed assets (finansielle anleggsmidler)
examples: Long term stock investments
According to Norwegian law, RL § 5-1, Fixed Assets are defined as assets which are supposed to be lasting ownership and useable. Examples of these are houses, apartments, assets, long-term stock holdings to name a few.
- Current assets:
A. Merchandise (varer)
B. Receivables (fordringer)
examples: Customer who needs to pay money to the business because they bought it on credit.
C. Investments (financials)
examples: Short term stock ownership (trading)
D. Bank deposit and cash
According to Norwegian law, RL §5-1, Current Assets are other stuff than fixed assets. The point is that these assets are way easier to trade than the fixed ones.
As you see, the left side of the balance sheet is about what the company owns. When a company earns more money, they can choose to invest more into the left side of the balance sheet, which again could result in an even bigger profit in the future.
The Funding Side
On the right side of the balance sheet, we have the financial aspect of our business. There are also two main sections here, namely Equity (Egenkapital) and Debt (Gjeld). It looks like this:
A. Deposited equity (Innskudd egenkapital)
B. Earned equity (Opptjent egenkapital)
A. Commitments (Erstatningsansvar etter ulykke, utsatt skattegjeld)
B. Other long-term debt (langsiktige banklån)
C. Short term debt (Kortsiktige banklån, leverandørgjeld, utbytte, betalbar skatt)
Very often, a company needs debt in order to be able to buy the assets that they want. The guys that give companies debt are the banks. However, these guys aren’t willing to just give anyone a loan. No sir! Often, the company needs to have a certain amount of equity in order to get approved from the bank. This is to make sure that the company is able to pay the debt without any problems. The normal ratio herein Norway is 40% equity and 60 % debt.
Let’s say you are the bank. Mr. Mister comes to your bank and wants to buy a house. You say, “Fine, how much do you want to borrow?” He says “$1 000 000.” You say, “Okay, how much equity do you have?” He says. “None.” So you say, “Well then, Mr. Mister, how on earth would I know if you’ll be able to pay back the loan that I would be offering to you?” He answers. “You wouldn’t know but you should trust me because I’m such a pretty lad.” Well, you get the picture. The bank needs to know that you have equity.
Two Major Risk Elements Regarding Debt
- Short term debt are bills that need to be paid ASAP and you need to have the money on hand or else you will get f***ed. As you understand, it’s critical that you have enough money to pay the short-term debt, unless you might be forced to sell some of your assets or even take another loan with very bad interests. The solution to short-term debt is for the company to have enough liquidity (likvidiet) which basically is the same as a measurement for figuring out how much $ you have on hand.
- Long term debt is not the same as short-term debt because it normally has way lower interest, and the guys that have given you this loan are normally way nicer than the short-term sharks. The solution to this is to have good solvency. Let’s explain that too:
In the long-term perspective, one uses solvency (soliditet) to figure out how much equity vs debt a company has. Good solvency can be seen as how stable and secure a company is. Again, say that Mr. Mister has $999 000 in his pocket, and he wants to borrow $100,000. Well, now you would say sure, why not. He can pay back the interest without any trouble.
Ooooooookay, so now we have talked about the balance sheet, WHAT WAS ALL OF THAT ABOUT STOCKLES?
So What About Dividends?
Well, the thing you need to understand is this: When a company has positive earnings, those earnings go straight to the equity part of the balance sheet. That money can again be spent on the left side, buying more assets which can make the business even greater, which again results in an even greater return for YOU. Or, it can reduce debt, or pay dividends.
So, what happens if a high yielding company doesn’t have positive earnings, but pays out dividend anyhow? Yep, you know it. They have to take money from the “equity bag,” which again will make the banks say Woooahhh hey there cowboy. Are you sure about that? How much are you taking? Can you pay the loans now big fellow? Sure? …. They might say, This is crazy! If you do this, we shall decrease your credit rating! And if they do that, they are basically saying, we are less sure that this company can pay its obligation than we were before.
So you see, the dividend payment isn’t just something magical which has 100% positive stuff along with it. It’s a fine balance, and you should always make sure you understand the risk when you invest in something!
A Few Short Words When Looking at Key Ratios:
- Price/Earnings is a ratio which we get when we divide the current share price over its past earnings. Here, the current share price reflects what the market values the company, and earnings (bottom line) is the what the company is left with after costs (debt, interest,…,) are subtracted from the revenue (top line). Note: Earnings is what keeps the ship from sinking.
NB: When looking at P/E ratios, you need to look at sector P/E. This is a much better ratio than P/E alone. Here’s why:
“One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money. As such, one should only use P/E as a comparative tool when considering companies within the same sector, as this kind of comparison is the only kind that will yield productive insight”
- Price/Book is a ratio which we get when we divide the current share price over its book value. The book which is referred to here is what is left if one sold all of the tangible assets (Apartments, Rentals, ships, machines, inventory) – the liabilities that the firm has. In super easy English, P/B = If one sold everything they could sell – what they need to pay the bank. As you see, P/B works pretty well for banks and insurance, because when they sell everything they have – their debt, there isn´t much stuff left, which means it’s quite accurate. For other stuff, like gaming companies, it’s harder to sell what they have (how do you sell the great concept of Call of Duty?)?
That was it. Now I hope you know a bit more about accounting, and with this in our head, we can finally analyse a few companies.
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