Chapter 15 – Shareholders’ equity

This section of the balance sheet represents the total value that is attributable to the owners (shareholders), after deducting all the obligations of the company, i.e. what portion of the assets is left for the shareholders after the company pays all its dues – to creditors (banks, bond holders), employees (pensions and salaries), taxes (accrued tax) etc. Thus, it is shown as below in mathematical form:

Shareholders’ equity = Total assets – Total liabilities

A lot of sub-headings come under this category, such as – Common stock, Retained earnings, Treasury stock and Other items (could be various form of reserves set aside by the company). As an investor, we are mainly concerned with the following two categories:

  • Retained earnings: This line item shows the accrual of reinvested income over the years. Let’s say a company makes a net income of $50k in the 1st year and distributes $10k to the shareholders as dividend. Remaining $40k is reinvested in the business, and this amount is added to the Retained earnings. In the second year, net income grows to $80k, out of which $30k is distributed to the shareholders. The remaining $50k is reinvested in the business, thus increasing the Retained Earnings to $90k ($40k + $50k) by end of second year.
  • Treasury stock: When a company starts buying back its shares in the market, it gets the shares back. Now it can either choose to keep them as Treasury stock in Equity section, or just cancel them out completely. Keeping them accounted for gives a flexibility to re-issue shares later to raise more capital if needed. If the shares are not cancelled, they sit on the company’s books as Treasury stock. These shares neither have any voting rights and nor any right over the earnings of the business, i.e. when the net income per share is calculated, these shares are excluded from the calculation. Do we like to see Treasury stock on the balance sheet? Yes, if the management buys the stocks back at a price lower than the intrinsic value of the business or, if the management thinks that it can’t deploy the excess capital in a manner that would increase the return for the shareholders. If the management is not able to find good projects to invest in, it can decide to return cash to the shareholders via dividends or share buybacks. Share buybacks are usually more tax-efficient way of returning cash to the shareholders, hence many investors like to see companies buying back shares.

Please note that sometimes a portion of reinvested capital can be accounted for under various categories within the Shareholders’ equity section. Some of these earnings can be allocated FX exposure buffer, which is there just to prevent loss from currency fluctuations effecting the business activities. All in all, what we really want to see is that the retained earnings and other buffers have been increasing consistently.

The value of Treasury stock can significantly lower the value of shareholders’ equity as it is carried in the balance sheet as a negative number. For such companies doing share-buybacks, you can add back the value of Treasury stock to remaining shareholder’s equity to see the trend of shareholders’ equity over the years.

Chapter 16 – Leverage

Chapter 14 – Long term debt and other liabilities

Chapter 9 – Balance Sheet basics

The balance sheet shows the state of company’s Assets and Liabilities:

  • Assets: We can consider this category of items as the investment made by the company to grow the business.
  • Liabilities: We can consider this category as the items indicating the obligations of the company.

Effectively, Liabilities primarily show the sources of cash for the business (please note that expenses like salaries to be paid to the employees are also included in liabilities as they also represent obligations of the company). Assets most likely show the uses of cash.

In case of Hot dog example, the owner uses his savings along with the money he borrowed from the bank to setup the company. These become the sources of cash for the company and hence, the liabilities, i.e. the company owes this money back to the bank and the owner himself.

When the company uses the cash to buy the Stalls and ingredients to make hot dogs, it is creating assets that can be used to generate more income. Please see below a sample balance sheet indicating the state of hot dog business:

HOT DOG BUSINESS
BALANCE SHEET
ASSETS LIABILITIES
INGREDIENTS $1,000 BANK LOAN $5,000
STALLS $11,000 OWNER’S EQUITY $7,000
$12,000 $12,000

As mentioned in Benjamin Graham and David Dodd’s Security Analysis, an investor can derive the following by carefully going through the Balance Sheet:

  • It reveals how much capital is invested in the business.
  • It reveals the easy or stringency of the company’s financial condition, i.e. the working capital position.
  • It contains the details of the capitalization structure.
  • It provides an important check upon the validity of reported earnings.
  • It supplies the basis for analysing the sources of income.

A typical balance sheet looks as below:

TYPICAL BALANCE SHEET
ASSETS LIABILITIES
CURRENT ASSETS: CURRENT LIABILITIES:
CASH & EQUIVALENTS PAYABLES
INVENTORY ACCRUED EXPENSES
RECEIVABLES SHORT TERM DEBT
OTHER CURRENT ASSETS OTHER CURRENT LIABILITIES
NON-CURRENT ASSETS: LONG TERM DEBT
PLANT & PROPERTY OTHER LIABILITIES
GOODWILL
INTANGIBLES SHAREHOLDERS’ EQUITY
LONG TERM INVESTMENTS PREFERRED STOCK
OTHER ASSETS COMMON STOCK
RETAINED EARNINGS
TREASURY STOCK
OTHER ITEMS (INCL. RESERVES)

I will touch upon the specific items in chapters ahead. We need to understand that studying the balance sheet is also a requisite for being a value investor. Sometimes, the opportunities arise in the stock market when the market punishes a company’s stock based on poor earnings announcements, while a careful look at balance sheet may suggest that the price of the share is better than the value indicated by the balance sheet.

Chapter 10 – Current assets

Chapter 8 – Income before tax, Tax expense and Net Profit