Reading Balance Sheets the Right Way
Trading at the Frankfurt Stock Exchange
Annual net profit, capital flow statement, equity ration - these
terms make many investors sweat. However, there are only few
important bits of data as our interview with financial expert
Bernhard Pellens, who is a lecturer at Bochum University, shows.
“No private investor has the time to review 100 or more entries on
the balance sheet of a company in which he invested. Nor does he
really need to. A few simple numbers are enough to get a clear
picture about a company’s financial condition.”
Aside from the bottom line and the profit-loss statement, the cash flow statement plays a very important role, according to Professor Pellens. That’s because this figure cannot be manipulated with accounting tricks, the expert says.
And what about measurements such as profit before interest and taxes (EBIT) or profit before interest, taxes, depreciation and amortization (EBITDA)? After all, they are presented as very important figures by both companies and the media. “I think this is not a useful debate,” the expert says. Neither Ebit nor Ebitda are decisive measurements for shareholders for the companies can determine how they calculate these figures, Pellens says.
What figures, then, should private investors pay attention to? For example, first take a look at the equity-to-assets ratio. In order to calculate this ratio, one needs a company’s balance sheet. From that, one picks out the level of proprietary capital and sets it in relation to total assets. The result says something about how the company is financed with proprietary capital. When banks rate a company’s creditworthiness, consult this ratio, among other things. Pellens says companies that are risky are those that have for several years a ratio of less than 10.
This gives the private investor an initial ratio that is easy to
calculate. Next, he should take a look at the cash flow statement.
This shows the investor how high the company’s total cash flow is.
Total cash flow can be divided into three areas: Operational cash
flow, cash flow from investment activities and cash flow from
According to Professor Pellens, the most important aspect of cash flow for the private investor is operational cash flow. This shows how much cash the company has earned from its operations. In other words: Cash flow reflects the balance between operational revenues in relation to operational expenditures. Of course, expenditures can be higher than revenue – which makes the cash flow a negative figure. If cash flow remains negative over the long-term, bankruptcy is the result.
Private investors should be interested in comparing operational
cash flow with net profit. If profit increases significantly but
cash flow remains relatively unchanged from the previous year, this
may be an indication of accounting manipulation. “Profit did not
increase because of cash flow; instead it may have gained because
of appreciation or a lesser depreciation or by absolving reserves,”
Professor Pellens explains. In other words, when one puts the cash
flow in relation to net profit, a private investor can see how much
his company has gained and how much of that has flowed into its
coffers. “It is very important that every investor take a look at
the long-term relation between cash flow development and profit
trends,” he says. If these two figures develop very differently
over a longer period, the investor should ask himself why.
Investors can also gain important information when they compare operative cash flow with borrowed capital. The result shows the shareholder how long his company needs to pay off its debts with operational income. This is referred to as debt repayment potential.
Investors should put the net profit figure found in the profit-loss statement in a second ratio: market value. “Hardly any company in the DAX is able to get an income-to-equity ratio of less than 10 percent,” Professor Pellens says. If one were to buy a share for more than €100, the return on the invested capital is below 10 percent for most DAX shares. “I think the income-to-equity ratio is a very important figure. If companies are not able to register a ratio of more than 10 percent for several years, the question begs as to why an investor should put his money in that company,” Professor Pellens emphasizes.
There is a very simple reason that a financial expert would favor
this ratio in particular: Operational cash flow cannot be
manipulated. Irregularities such as sudden gains are visible and
have to be explained. Profits, in contrast, can be influenced by
corporate politicking, so-called earnings management. Company
management can affect these statistics with appreciations,
write-offs or by dissolving reserves.
But if profits can be manipulated, why should an investor use net profit as a core statistic? “The annual net result is calculated according to fixed rules. Unlike with Ebit, the company cannot determine how net profit will be calculated,” the professor says.
Sales, or revenue, plays a more or less secondary role for the professor. It can be a reason for increased profits, but does not necessarily have to indicate that. Better cost management or improved productivity can lead to profit gains despite declines in revenue.
“I think if shareholders know about the ratios we discussed, he is well-armed and can get a sufficient picture about a company’s financial condition,” Professor Pellens says. What’s important is that shareholders don’t just read the annual report, but also look at quarterly reports. They are more current than the report that appears just once each year.
*Bernhard Pellens is a lecturer at Bochum University, where he holds a chair in International Corporate Accounting. Together with his team, he has compiled the so far largest study on investors' behavior in Germany - on behalf of Deutsche Post AG and the monthly business publication "Capital". Almost 70,000 investors took part in this survey. The majority of the surveyed private investors invest in shares in order to build up assets in the long-term. Only 7 percent want to generate profits in the short-term. However, the portfolios are hardly diversified: almost 13 percent of investors hold a single title; 12 percent each hold two or three titles in their depots. A mere half of all participants actually follows the recommendation of Deutsches Aktieninstitut to hold five to the different titles in their depots. Many investors set value on a dividend. The majority would choose to do without voting rights and instead buy preferred shars for higher yields.