It's a complex topic, but fortunately, no one needs to be a certified public accountant, accounting professional, or tax expert to understand it. The goal is not that, but to provide insight into corporate data, which can be used to analyze stocks. Of course, you can buy a stock because it "has a good story," but that's called speculation. You can also use technical analysis, which is when you examine the movement of stock prices. Fundamental analysis is the study of a company's financial data, and this requires a balance sheet and income statement, which companies must publish in their quarterly or annual reports.
The purpose of analyzing the balance sheet and income statement is, among other things, to determine whether, based on the company's data, its activities and processes can be sustained and its results can be increased. You need to get an answer to whether the indicators are improving, whether profitability is increasing, whether value is being created, etc. Apart from short-term fluctuations, periods of mania and panic, there is a positive relationship between a company's profit-making ability and its share price. If the market judges that a company will prosper, this will usually be reflected in a rise in the share price. In a good case, this will also be reflected in the balance sheet and income statement figures.
Balance sheet and income statement: Where to find data?
I will use significant simplifications to make the topic easier to understand, so I would ask certified accountants to read the article with this in mind.
Usually, when it comes to the balance sheet and income statement, they start with an explanation of the concepts. However, I will not start with that now, as I would like the reader to follow the entire train of thought with me. And for this, data sources are needed, otherwise the topic of the balance sheet and income statement will just degenerate into an incomprehensible set of concepts.
Each country has its own system for storing and publishing financial reports, for example, the financial data of companies in Hungary is public and electronic reports are available on the website of the Ministry of Justice:
Foreign data sources
Data on American companies can be found in many places, there are countless sites specializing in this, I will list some of the ones I use:
- Edgar database: the website of the US Securities and Exchange Commission, where companies listed on the US stock exchange must officially upload their financial statements. Of course, other types of documents can also be found here, e.g. bond issuance, matters related to management changes, etc. The 10-Q designation covers quarterly reports, and the 10-K designation covers annual reports.
- Investopedia: not so much a data provider, but more of a glossary of sorts that explains various abbreviations and technical terms. In many cases, there are also video explanations, which makes understanding much easier.
- iO Charts: I don't need to explain why it was included in the list. The point is the graphs, from which the trend can be read at a glance. Visually, it is often easier for the trained eye to process what it sees, and it complements the sheer numbers well.
- Fiscal.ai: the best stock selection site on the market, with relatively friendly pricing. It can draw great charts, which I use for iO Charts for stock analyses.
- Gurufocus: provides a brutal amount of data, and these can be downloaded in XLS and PDF formats. The site is difficult to use, you need to get used to it, and their premium service is quite expensive.
- Morningstar: I mention this because Interactive Brokers clients have free access to Morningstar analyses, which contain financial data.
- finviz: although it doesn't provide cash flow data, it does provide a lot of indicators, it has some extras, and it's completely free.
Overall, I think that when it comes to balance sheets and income statements, there isn't really a single page where all the necessary data is available. Not least because the number of different indicators is almost endless.
Balance sheet and income statement: what is it all about and what is it good for?
It is important to note that when the topic of the balance sheet and income statement comes up, in this article it is mentioned exclusively in the context of company analysis. I am specifically considering the perspectives of stock market investors, rather than using an accountant's or accounting approach.
For those who want to analyze companies, I highly recommend Thomas R. Ittelson's book (Thomas R. Ittelson - Financial Statements: a step by step guide to understanding and creating financial reports). It's a rather difficult work to read, but it's worth suffering through it once.
The balance sheet and income statement are important because you will only be able to make informed decisions if you have information about the company. It is the Swiss army knife of fundamental investors, a “lexicon” from which you can read the essence. Without it, you would have to choose between companies blindly. Since you make investment decisions related to stocks for a minimum of 5-10 years, interpreting the balance sheet and income statement is essential. Obviously, if you are speculating or intraday trading, the underlying fundamentals are irrelevant to you.
What is the accounting balance sheet?
The balance sheet is a document that records the company's assets. According to Wikipedia's definition: “The accounting balance sheet is a statement that shows the composition of a company's assets (assets) and the source of financing for these assets (liabilities) at a given point in time."
The balance sheet consists of two parts, the liability side and the asset side. The former tells you where the money comes from, which can be equity, debt, share issues, etc., and the latter tells you what the money was spent on. It is called a balance sheet because the two must be in balance. You will find the asset side called assets, while the liability side is called liabilities and stockholder equity, which is the total of receivables and shareholders' equity. The liability and asset sides must match, and they basically show a current state.
What is an income statement?
The income statement shows the difference between revenues and expenses for a given period. If it is positive, the company is making a profit, if it is negative, it is making a loss. I can also put it this way: the income statement provides information about the company's ability to generate profits. Investors typically determine this information by calculating various financial ratios. Don't worry, there is no big math behind it at our level, the data providers simply return the calculated values to you.
You can almost always find financial data under the financials tab, the balance sheet is the balance sheet, and the income statement is the profit and loss statement. I would like to draw your attention here to the fact that you will often stumble upon different data on different data-providing sites. This can be especially problematic if they calculate complex formulas, as in this case the data can be distorted exponentially. ALWAYS check the numbers from multiple sources, never trust the data from a single site.
Using the balance sheet and income statement
Let's look at an example of the balance sheet and income statement, but before you start the analysis, I would like to draw your attention to a few things, because things can be confusing:
- What time period do the numbers refer to? It's important to see whether you're looking at an annual or quarterly breakdown. Some companies, such as tax-related companies like H&R Block (HRB), collect the majority of their revenue in a single quarter. Companies in cyclical sectors have numbers that fluctuate over a multi-year economic period. Typically, these are companies in the industrial or mining sectors.
- How many years of data are available. Better data providers provide data going back 20-30 years, and charge a fee for it. This is important because this is the only way to estimate trends.
- What is in the column header. It is important that the numerical value is the number you see in the given row, thousand, million, billion, and also the currency in which it is given.
- Values in parentheses represent negative numbers. Certain items should be subtracted, not added.
Another common problem is that some companies are listed on multiple exchanges, meaning you can see their data in different currencies. A good example of this is Evolution Gaming, which I also analyzed (Evolution AB analysis), which is listed on both the Swedish and American stock exchanges, in the former case the figures are displayed in Swedish kronor (SEK) and in the latter case in US dollars (USD). Since 1 USD is roughly 10 SEK, it is very easy to misread the figures and make an order of magnitude mistake.
Interpretation of the balance sheet and income statement
The image below shows the assets and liabilities side of the balance sheet and income statement of Evoluting AB (EVVTY). Unfortunately, it didn't fit in the image, but as I mentioned earlier, the total assets plus total equity and liabilities are the same, amounting to 5964.8 million USD, so the balance sheet remains balanced.
💡To make it easier to understand how it works, I'll give you a simple example. Evolution AB (EVVTY) buys a car so that IT specialists can go to each site. The car costs 20000 USD. From an accounting perspective, all that happens is that the purchase price of the car is deducted from the available cash on the asset side, while the car is added to the inventory category on the assets side for the same amount. In other words, we have exchanged two assets. The situation would be different if the company bought the car on credit, in which case a loan worth 20000 USD would appear on the source side, while the car would appear as an asset on the asset side. I won't go through every line, I'll just highlight the most important things.
Assets
- Fixed assets: Assets that serve the company's operations over the long term, beyond one year. Examples include production lines, the land belonging to the factory building, the real estate on it, vehicles, etc.
- Intangible assets: There are tangible assets, you go there and grab them, and intangible assets, which are the opposite. They serve the company's activities directly and permanently and are not financial in nature. For example: intellectual products such as know-how, patents, software, business or goodwill, etc.
- Current assets: Assets that are exchanged in the short term in the company's production cycle, i.e. they are current. This can be cash or equivalent short-term instruments, such as inventories, receivables, and so on, but you can read what belongs here from the individual lines of the balance sheet.
📌Practical example: In relation to intangible assets, we need to address goodwill, such as customer loyalty, brand value, market share, management expertise, i.e. assets that cannot be touched or depreciated (for example, software is also an intangible asset but can be depreciated). High goodwill tends to be a problem when a company makes too many acquisitions, for which they pay much more than the fair value. In such cases, goodwill is written off, which is a significant destruction of value from the shareholder's side.
In the image above you can see the change in the business and goodwill value of AT&T Inc. (T). The company with a market capitalization of 200 billion USD wrote down its business and goodwill value from 146 billion USD to 68 billion in three years, which means a decrease of 78 billion USD! That is more than a third of the company's value, and it is no coincidence that the share price also plummeted at that time.
Liabilities & Stockholders' equity
- Equity: the amount paid by the owners when the company was founded, or received during a capital increase, or for the issuance of shares. In exchange for purchasing the shares, the investor receives a stake, or ownership, in the company. Retained earnings from previous years' profits are also included here (which can be negative).
- Long-term liabilities: The counterpart of fixed assets is any liability that matures in more than 1 year.
- Current liabilities: The counterpart of current assets is receivables with a maturity of less than 1 year or that are about to expire.
📌Practical example: long-term liabilities are practically debt. Unfortunately, there are a lot of zombie companies operating in the market with huge debts, such as telephone companies, the oil sector, but even pharmaceutical companies suffer from this situation. This is very dangerous because in a recession, when revenues dry up, the debt has to be paid anyway, and the interest rate environment often changes at this time. And it is difficult to refinance debt at a higher interest rate, which has already led to the downfall of many companies.
In the image above you can see the debt of Exxon Mobile (XOM), the 2020 downturn is the period of the closure of the COVID pandemic. I have written about oil companies several times, but the numbers show very clearly how debt has skyrocketed and revenue has plummeted. I have also included the ratio of net debt to EBITDA on the graph, which will be discussed later, of course you can also find these in a company's balance sheet and income statement.
Income statement lines
The income statement always includes the previous year's results. Often, the change from the previous year is also shown, usually as a percentage. In the income statement of Evolution AB (EVVTY) shown in the image, the lines are as follows:
- Revenue: The total revenue of the company. This is usually further broken down into various items – e.g. revenue growth, cost per revenue, etc. Deducting all costs will give you the business profit.
- Operating income: Sales and marketing, administrative, research and development and other operating costs must also be deducted from the gross profit.
- Profit before tax (EBIT): In English, EBIT, usually the tax rate is also indicated in the breakdown, the difference between the two is the after-tax profit for the current year/quarter.
- Operating expenses: the total costs associated with the operation of a company. This can consist of many things, e.g. personnel or real estate costs, depreciation, amortization, research and development, etc. This is basically a very good indicator of the cost structure of a company.
- Interest expense: The figure shows such low numbers that the company has practically no debt.
Data analytics sites usually also show all sorts of other metrics, such as earnings per share, cash, dividends, various return ratios. The main categories can be further divided into subcategories, if you are interested, you can take a look at Finchat.io, for example.
📌Practical example: you can calculate margins from the above figures. Why are margins important? Because they show how effectively a company can price its activities and how much capital it needs to maintain its business. The higher the margins, the better. High profit margins are also beneficial in times of high inflation, because if a company cannot pass on costs to the consumer, it has to absorb them. Companies with a strong competitive advantage will of course pass them on, but if not, it matters a lot that it has to absorb 5% inflation from a 100% or 30% gross margin. Also important are the net margin after tax and the FCF margin (Free Cash Flow). The former shows how much money the company has left after taxes, and the latter shows how much cash it has to generate.
Basically, I always strive to choose companies within an industry as investment targets that have higher margins than their competitors. In other words, the balance sheet and income statement can be used to determine the quality of the company and, in the long term, to generate extra returns, or money.
What can be read from the balance sheet and income statement lines?
Now that you are familiar with the theoretical foundations, it would be good to know what all this is good for. Mostly to spot certain things in the statements. Basically, you need to pay attention to the trend, there are no hard and fast truths, but if the numbers are constantly showing a worsening direction, or some indicators are too high or too low, then you should be suspicious. Let's look at some examples of the above.
Increasing cash balance: If there is constantly more money, it is a good sign, right? Yes, and no. If you see a continuous increase in the cash section, it means that the company is a “cash cow”, meaning it is able to generate profits and accumulate the money from this. This is pleasing from the point of view that the company is profitable in the long term, but something should be done with this amount of money. The cash can be paid out in the form of dividends or reinvested in productive activities, or it can reduce loans, if any. A lot of “extra” cash can pave the way for the repurchase of its own shares, which can have a price-raising effect. However, it is also possible that the company does not know what to do with the money, or is about to make an acquisition, and is therefore accumulating it.
High ratio of property, plant and equipment to total assets: These are physical assets, typically listed as a significant item on the balance sheet of manufacturing companies. If this is not the case, there is always a reason for this, which needs to be checked separately. The same is true the other way around, in the case of a service company, the proportion of intangible assets should be high.
High intangible assets: the opposite of the previous one, a collection of intangibles, licenses, software, trademarks, and the like. For software companies, it is quite natural that it is high, but for a real estate management company, I would look at what this category includes.
Balance sheet and income statement: Credit and indebtedness
This is a more complex topic, but the gist of it is that if a company is in debt, it can significantly reduce its ability to generate profits in the long run. There are several reasons for borrowing. If it covers its daily operating costs, it is usually a bigger problem, than if the loan is needed for expansion or increasing the size of the plant, then it is more acceptable. Many companies use credit as a quasi-“capital leverage”, they get money cheaply in a low interest rate environment, and use it to finance expansion. One possible source of income is when the company obtains capital through share dilution (selling shares to new investors, thereby reducing the ownership of existing owners). There are companies where this process is coded into their operations, such as property managers, utilities, etc. You will typically encounter it in companies where the activity is investment-intensive.
It is important to consider when the loans you have taken will mature. It may be that this will happen in 10 years, and until then only interest will have to be paid back, or the entire amount will have to be paid back in a given year. A company can still be viable with high levels of debt, e.g. AT&T (T) has been struggling with significant debt for many years, and thankfully, it's doing well. A counterexample is fund managers: their debt is typically close to 0, e.g. T. Rowe Price Group (TROW).
📌Practical example: I basically like companies where net debt is negative, meaning cash is greater than long-term liabilities. This means that the company could pay its liabilities at any time, but it doesn't because for some reason, for example, because the interest rate environment is low, credit is advantageous for it. In this respect, fund managers are outstanding, their model is very non-capital intensive and they generate a lot of cash, so they almost never have debt. I wrote about this when I analyzed the aforementioned fund manager: TROW Stock Analysis
Financial indicators that can be calculated based on the balance sheet and income statement
I've included a picture of Finviz to demonstrate how many indicators you can choose from. Different stock analysis sites love to come up with all sorts of aggregated values called scores, but they still don't do a very good job of predicting the future. I've highlighted a few basic indicators that are widely used. But you can find six hundred and fifty others on the internet anyway, everyone uses the one they think is most useful.
The basis of all such indicators is that investors really want to know how much a company is worth, that is, what its valuation is. Here are some of them:
P / E: shows the valuation of a company's stock, practically a price/earnings ratio. For example, if the P/E ratio is 15, it means that the company would recoup its price in 15 years with its current constant, non-growth earnings. In reality, there are many problems with the P/E ratio, it does not show true valuation, it can be distorted, for example, by buying back its own shares or in other ways, and it is not usually used by banks and REITs. We wrote about this problem in detail in a previous article: Using EPS and PE indicators
Would you rather have something else instead of P/E?
P/B: compares the company's market capitalization to the company's book value. The logic is similar to that used for the P/E ratio. If the P/B ratio is 5, then the total value of the shares is five times the value of the company's equity shown in the books. This type of metric has been useful for a long time, and it can also be associated with one of the strategies of perhaps the world's most famous investor, Warren Buffett, and is known in English as: "Cigar Butt". The problem is that a significant part of the value of modern service and IT companies is made up of intangible assets, making it difficult to use for valuing many companies.
P / S: Similar to the previous metrics, but it compares the company's market value to its revenue. The logic is the same as before, if the P/S is 10, then the company can generate as much revenue as its value in 10 years. It is easy to see that we cannot draw conclusions from revenue alone, for example, we do not know whether the company is profitable, whether profits are growing, how efficiently it produces, etc.
ROE, ROI, ROA Return on assets: Each return on assets ratio represents the return the company has achieved, based on a certain balance sheet category. In the case of ROE, it is based on equity, in the case of ROI, on invested capital, while in the case of ROA, it is based on total assets. For example, if the assets are 100 USD and the after-tax profit is 10 USD, then the ROA ratio will be 10%, and so on.
Debt and liquidity
Indebtedness indicators: They tend to assign a lot of different values to debt and create a ratio from it. One of the main problems with companies is indebtedness. The burden of this depends significantly on the interest rate environment, it is important whether 2% or 10% interest is paid on the debt. One such ratio is debt/equity, where the amount of debt is compared to the equity. The other is net debt/earnings before taxes. Net debt is nothing more than subtracting cash from debt.
Liquidity indicators: Liquidity ratios indicate how solvency a company is. The current ratio compares current assets to short-term liabilities. The quick ratio uses a similar but more complicated formula, which you can see here: Quick-ratioA value of 1 is usually considered good; below 1, the company cannot cover its short-term liabilities, and above 1.5, the company cannot – or does not want to – do anything with the accumulated cash.
I would like to add a few empirical examples to the above indicators. One is that some stock selection sites display negative numbers, while others do not display the values at all. This can be due to several things, for example, the fact that most of the indicators consist of mathematical divisions. If the denominator contains a zero or negative number, then either the division cannot be performed or a meaningless result is produced.
Where can there be a trick in the balance sheet and income statement data? What exceptions are there?
First of all, accounting operates according to certain rules, which are set by the laws of the given state. In Europe, this standard is called IFRS, and in the USA, it is called GAAP. Where this is not followed, it is called non-GAAP. This can cause confusion, the bigger problem is that what is correct from an accounting point of view is not necessarily beneficial in reality.
For example, a company's management may withhold profits, especially if executive compensation is tied to some profit metric. They may postpone their developments, which may hurt the company's profitability in the long run, but may improve results in the short run. The sale of components has the same distorting effect. For example, the sale of a plant appears on the income side for, say, $5 billion. This plant had $500 million in annual profit-making capacity that was eliminated from the current year. This represents a one-time gain of $4.5 billion, which improves current figures, in exchange for future profit losses.
The balance sheet and income statement don't show everything.
There are also problems arising from the way accounting works. For example, accounting does not take into account opportunity cost. This means on the investor's side that if you invest your money in option A, you lose the return on option B. For example, if you open a shoe store with 1 million USD and it produces 100 thousand USD. If you invest the same amount in government securities, for example, then at 6% interest, your profit would be 60 thousand USD. In other words, the difference is actually only 40 thousand USD.
There are many companies that conduct significant research and development, such as semiconductor manufacturers or pharmaceutical companies. These costs are written off in a given accounting year, while their impact can span years, but this also applies to the positive return of an advertising campaign, for example. It is also worth mentioning the level of capital expenditure. This is the essence of how much capital the company must reinvest in order to achieve future results.
This is not recorded in the same accounting records as the amounts spent on research and development. However, some companies are forced to continuously develop, e.g. Intel (INTC) spends $20 billion a year on research and development, but the same is true for the development of drugs, which consume an average of over $2 billion, without which pharmaceutical companies would not be able to maintain their profit-making ability.
The balance sheet and income statement and the value creation of companies
I would only touch on the value creation of companies for a paragraph. It is very important how a company uses the profit it generates. There are value-creating and value-destroying activities from an ownership perspective, and obviously the former is advantageous as a shareholder. This is quite difficult to read at a glance from the balance sheet and income statement lines:
- buyback of own shares: On the one hand, it has a price-boosting effect in the long term, and on the other hand, no dividends need to be paid on the repurchased shares. Another effect is that it increases earnings per share, which reduces the P/E value, but in the case of a stock that is expensively executed, i.e., one that is trading above the company's fair value, the repurchase of its own shares can also be value-destroying. The legendary form of this technique is cheap repurchase, expensive issuance: Harry Earl Singleton
- dividend payment: the company can pay out some of the cash to the owners. There is an underlying “mystique” to dividends that only what the company has produced can be paid out, but I could give a counterexample. Of course, paying dividends can also mean that the company cannot use the money it has produced efficiently.
- investments supporting organic growth or process development and optimization: There are many ways to generate extra profit, including reducing costs, optimizing processes, and making all kinds of investments. The effectiveness of these is difficult to judge in the present; the future usually provides the answer to whether they are successful.
- debt reduction: It is good for a company to reduce its debt for two reasons. First, it means less interest is paid on a lower amount, and second, the company normally borrows it to finance value-creating investments.
Balance sheet and income statement: accounting minefield of share buybacks and share dilution
Share buybacks are not free for the company, as they have to buy them from the market at the given price, so naturally they are included in the appropriate line of the balance sheet and income statement. Share buybacks are beneficial when the price is low, and shares need to be diluted when the price is high.
Shareholders love share buybacks because they boost the stock price, as many metrics are calculated based on how much something, such as revenue or profit, comes out of a single share. Companies that buy back their own shares on a large scale are often called cannibal companies.
📌Practical example: The company's shares can be diluted not only by issuing shares, but also by giving management unrealistic option compensation. These are callable stock packages that are fixed in price and create additional shares, i.e. increase the total number of shares, thereby supplementing management's salary. How do they cover this up? Of course, by buying back shares, which if the value is higher than the management's option compensation, then it only looks like a small share buyback. It's always a red flag when you see this, a good example of this is Veeva Systems (VEEV), which pampers its executives with outrageously high bonuses. You can see the percentages as a percentage of revenue.
💡It is often tricky to account for in the income statement, usually the operating costs are listed, while in the balance sheet the equity portion increases, but does not appear on a separate line. However, in the cash flow statement it is, it is worth looking here.
Read between the lines!
The main problem with these is that they are relatively difficult to read from the balance sheet and income statement data. In many cases, you have to look at the news about the company separately, understand their philosophy, read the quarterly reports, look at the composition of their debt, what the interest burden is, and so on. What did management say and what did they keep from it, so the numbers alone are not good for everything.
Summary
The analysis of the balance sheet and income statement is a long-winded topic, but I have tried to summarize the essence and support the essence with examples. Fundamental analysts use these statements to examine companies. Of course, they also use countless indicators, which are compiled from the numbers of the income statement, I have only listed the typical ones. However, there are elements that cannot be read from the lines of the balance sheet and income statement, and you should pay special attention to these. Fundamental analysis is not a miracle weapon, but if used wisely, you can form a more in-depth picture of the company whose shares you are going to buy.
Since this is a very dry topic, don't focus on understanding everything, just recognize the patterns. If a company has a lot of debt, look at why. If the company has a share buyback program but the number of shares is barely falling, that also says a lot. High revenue but little cash is generated? The business's operating structure is probably not good. Does the company have enough resources to pay dividends? Questions like these and similar ones can be answered by understanding the balance sheet and income statement.
Frequently Asked Questions (FAQ)
What is a balance sheet and income statement in a foreign language?
Since most stock analysis is done in English, it is worth listing some terms in English to make it easier for you to search the data. Fortunately, artificial intelligence can now translate any language into your own language relatively easily, but if you are searching on a picture chart, for example, it is not so simple:
- financials, usually this includes three sub-segments
- income statement, or profit and loss statement (P&L)
- balance sheet
- cash flow statement
What is an IFRS income statement?
The IFRS income statement is an income statement according to International Financial Reporting Standards. This statement presents the profitability of a company for a given period according to international rules. The American equivalent is GAAPS.
Typical items in the content of an IFRS income statement may include:
- Revenue – Revenue
- Cost of Sales / Cost of Goods Sold (COGS) – Cost of goods sold
- Gross Profit – Gross profit
- Other income – Other income
- Distribution Costs – Selling expenses
- Administrative Expenses – Administrative and general costs
- Other Expenses – Other expenses
- Operating Profit (EBIT) – Operating result
- Finance Income / Expense – Result of financial operations
- Profit Before Tax – Profit before tax
- Tax Expense – Taxation
- Profit for the Year – Result for the current year (net profit)
What does after-tax profit mean?
Companies generate revenue by selling products and services. However, there are many items that you need to subtract from this revenue to get the right metrics:
- gross profit: the cost of goods sold must be subtracted from revenue, i.e. revenue-COGS
- Operating result: Sales and marketing, administrative, research and development and other operating expenses must be subtracted from the gross profit. The remainder is also called EBIT after the English abbreviation
- EBITDA result: also an English acronym consisting of EBIT+amortization+depreciation
- net profit: EBITDA profit after taxes
EBITDA is the profit that is usually determined immediately before taxes, but you still have to subtract interest expenses or add interest income from it, which is what makes up the profit before taxes. It is not difficult to guess that if you subtract taxes from the above, you get the profit after taxes.
The above is interesting because if you divide these indicators by total revenue, you get margins, such as gross margin or EBITDA margin, which will be a percentage value and show the operating efficiency of companies.
What is the meaning of acquisition?
Acquisition literally means takeover, in English it is abbreviated as M&A, which stands for merger and acquisition. A company can carry out an acquisition in several ways: it can pay for it with cash, through share dilution, or it can also take out a loan, all of which will appear in the income statement.
What is the meaning of capex and opex?
In English, it means capital cost and operating cost, that is, the expenditure that must be reinvested into the business to maintain the operation of the company. The lower the capex cost of a company, the less capital intensive it is, such as software companies, insurance companies, service providers. The opposite is the case for capital intensive companies, such as mining companies, utilities, and basically industrial activities, where significant investments must be made to operate.
What does debt mean?
It literally means debt when a company takes on external resources, effectively a loan, in its business. This amount is also included in the income statement, since the loan, in addition to providing funds for the company, also represents an interest and principal repayment obligation. You get net debt by subtracting cash from debt. Where you see negative debt, cash exceeds total debt.
What does EBIT mean? What does EBITDA mean?
EBIT means earnings before taxes, while EBITDA is the same, only adding depreciation and amortization. Basically, companies refer to their EBITDA results because in many countries the tax bracket they have to pay taxes on can change from year to year. Therefore, it is a relatively exact number that indicates the operation.
Interpretation of debt ratio
There are several types of debt ratios, depending on what the debt is compared to. The most common are the following:
- Debt/equity ratio: total liabilities / Equity. It shows how many HUF of liabilities there are for every HUF of equity. The higher the number, the more indebted the company.
- Debt/asset ratio: Total liabilities / Total assets. It shows how much of the assets were financed from external sources. If this value is 0,6, then 60% of the assets are financed from loans.
- Long-term liabilities ratio: long-term liabilities / Total assets. Measures the company's long-term indebtedness.
- Interest coverage ratio: EBIT / Interest Expenses. It shows how many times the company can cover its interest expenses from its operating profit. A value above 3 is considered acceptable.
- net debt/EBITDA: (Long-term + short-term debt – cash) / EBITDA. One of the most important indicators of financial analysis. It indicates how many years the company would be able to repay its debt with the current EBITDA.
I don't really like the interest coverage ratio, because if you have to look at a company to see if it can cover its interest payments in the long term, it's usually in big trouble. If this ratio is low, it almost always means a dividend cut, forced sale, share issue, or some similar event. On the other hand, the net debt/EBITDA ratio is extremely useful and shows clearly whether the company is just using loans as a form of leverage or whether it is truly in trouble.
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