DE ratio helps measure the solvency position of a firm.DE ratio helps measure the solvency position of a firm.DE ratio helps measure the solvency position of a firm.

By N Sivasankaran

balance sheet is one of the three important financial statements to be prepared and reported by a public limited firm in its disclosure documents (quarterly/ annual results) to the public. It reveals the sources and uses of funds of a firm as on the date of reporting. Let us check the five major items to look for in a balance sheet.

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Shareholders’ funds
This is the most important number to look for in the balance sheet. Consider only the amount of reserves and surplus (other equity) and the trend of it over the past three to five years. A good stock is one which reports an increasing trend in its reserves and surplus amount over the past. If one wants to compare two or more firms (or two or more periods for the same firm) on the reserves and surplus, then it is better to scale it to the total assets so that the data is normalised for comparison.

Non-current assets (NCA)
Look for the change in the proportion of NCA to total assets of their target firms. Consider the sum of property plant and equipment (PPE) and capital work in progress (CWIP) as a proxy for tangible NCA in case of manufacturing firms. For service and merchandising firms, look at the total of NCA for the ratio calculation. Higher the ratio, better is the future potential of the stock. A firm with an increasing trend in the ratio is a good buy candidate.

Working capital to total assets
Working capital is the requirement of funds for meeting the operating requirements of firms. It is computed by subtracting trade payables from the sum of trade receivables and inventories. An increase in working capital indicates the firm is wasting its capital, reducing its profitability. Decrease in it reveals the firm is releasing cash for investment in other productive investments. Also look at the liquidity requirements of firms while making inferences on this ratio. When one scales WC to total assets, it becomes a normalised figure which can be used in both intra and inter firm comparisons.

Debt-to-equity (DE)
DE ratio helps measure the solvency position of a firm. Lower the DE ratio of a firm, better the ability to honour long term obligations. This ratio is critical for firms in highly leveraged industries. The benefit of debt (increase in ROE) must be weighed with the cost of debt (increased beta).

Cash is objective, and it is not affected by accrual accounting. It is better to scale it to total assets so that we can compare a firm both on intra-firm and inter-firm basis. A firm with higher cash to total assets must be backed by plans for future investments (either in PPE or through acquisitions), else it may be wasting the funds.

These are the major numbers to be checked when analysing the historical financial performance of target firms for investment. It is always better to look for a trend in these items instead of considering just the latest quarter/year.

The writer is associate professor of finance, XLRI – Xavier School of Management, Jamshedpur

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