|Posted by SRIKANTHBABU KALIKI on September 2, 2010 at 1:10 PM|
What is investing?
Investing lets your money earn some more money, thus getting it to work harder for you. In effect, your savings do not sit idle, but help you profit from them. Why should you invest?There are two main reasons why you should invest:To stay ahead of inflationAs the cost of living keeps increasing and day-to-day expenses keeps rising, investing lets you keep pace with thesechanging market conditions.To achieve financial goals As the saying goes…A journey of a thousand miles, begins with a single step. Investing small amounts of money over a period of time brings you closer to your financial goals.
When should you invest?
With investing, time makes money. Thus, the earlier you start investing the better, since you can reach your financial goals faster. So, regardless of your financial position, investing ensures that you accrue wealth over time.
Where do I start if I have no savings?
The first step to investing begins with saving. You can stay invested, even by saving small portions of money on a monthly basis. Thus, the first successful investment decision, is the decision to start saving, however difficult it may seem at first. After all, where there is a will, you will always find a way!For eg: If your monthly salary is Rs 20,000 per month and your monthly expenditure is Rs16,000 per month, park the difference of Rs 4,000 into an investment avenue of your choice immediately.
How can I invest if my savings are meagre?
The amount invested does not restrain earnings, as long as you keep investing regularly.
What's the next step after my first investment?
Investing is a lifelong activity; you need to keep investing regularly. To know about investment opportunities, keep reading up about financial markets and companies.
How Do I Get to My Allocation Goal?
Financial goals can be separated into two types:Short-term goals - Are immediate goals,ones you would want to achieve now or within a year.For ex- Buying a computer,a bike,a mobile, music system, DVD player etc.Generally,it takes less money to reach these short-term goals.Long-term goals - Take you a longer time to reach and need adequate planning, as they involve larger sums of money.For ex. Buying a luxury car,buying a house,and even starting a business.Often, it is the first step towards investment that seems to be the hardest.However, with adequate planning and a clear focus on the objectives, you could attain your goals with ease.You should always plan for your goals taking into consideration your risk-return appetite and accordingly apportion your funds into various channels.
What are the basics of financial instruments?
Let us understand the two fundamental types of investments, namely bonds and stocks with an example. Eg. Imagine you want to start your own grocery store. You will need a capital amount to get started. You acquire the requisite funds from a friend and write down a receipt of this loan ' I owe you Rs 1, 00,000 and will repay you the principal loan amount plus 5% interest'. Your friend has just bought a bond (IOU) by lending money to your company.
Thus a bond is a means of investing money by lending money to others. When you invest in bonds, the bond you buy will show the amount of money being borrowed (face value), the interest rate (coupon rate or yield) that the borrower has to pay, the interest payments (coupon payments), and the deadline for paying the money back (maturity dates).
There are several Pro's and Con's to investing in bonds.
Ø Bonds give higher interest rates compared to short-term investments.Ø Bonds are less risky when compared to stocks.
Ø Selling bonds before they're due, may result in a loss, known as a discount.
Ø If the issuer of the bond declares bankruptcy, you may lose your money. Hence you must critically evaluate the credibility of the issuer of the bond, ensuring that he has the capability to repay the bond amount.
Now, let us continue with the same example. To accrue more capital for your new grocery store, you sell half your company to your brother for Rs 50,000. You put this transaction in writing 'my new company will issue 100 shares of stock. My brother will buy 50 shares for Rs 50,000.' Thus, your brother has just bought 50% of the shares of stock of your company.
Thus, to explain stocks:
Stocks, also known as Equities, are shares in a company. It is the certificate of ownership of a corporation. In simple terms, when you invest in a company's stock or buy its shares, you own part of a company. Thus, as a stockholder, you share a portion of the profit the company may make, as well as a portion of the loss a company may take. As the company keeps doing better, your stocks will increase in value and yield higher dividends.
Dividend: A sum of money, determined by a company's directors, paid to shareholders of a corporation out of its earnings.
This example covers the 2 major types of investments: bonds and stocks.
Rewinding back to the Stock Market Trading history of India
In the earlier days, stockbrokers kept scouting for 'natural' sites to conduct their trading activities, shifting from one set of Banyan trees to another. As the number of brokers kept increasing and the streets kept overflowing, they simply had no choice but to relocate from one place to another.
Finally in 1854, trading in India found a permanent address, Dalal Street, now synonymous with the oldest stock Exchange in Asia, The Bombay Stock Exchange. With a heritage that goes back to over 130 years, BSE was the first stock exchange in the country to be granted permanent recognition under the Securities Contract Regulation Act, 1956. The exchange has played a pioneering role in the development of the Indian Securities Market - one of the oldest in the world. After India gained independence, the BSE formulated a comprehensive set of guidelines adopted by the Indian Capital markets. Even today, the BSE Sensex remains one of the parameters against which the robustness of the Indian Economy and finance is measured.
The trading scenario in India then underwent a paradigm shift in 1993, when NSE or National Stock Exchange was recognized as a Stock Exchange. Within just a few years, trading on both the exchanges shifted from an open outcry system to an automated trading environment.
Today, the Indian Securities market successfully keeps pace with its global counterparts through the use of modern day technology.
Stock market milestones
1875 BSE established as 'the native Share and Stock Brokers Association'
1956 BSE became the first stock exchange to be recognized under the Securities Contract Act.
1993 NSE recognized as a stock exchange.
2000 Commencement of Internet trading at NSE.
2000 NSE commences derivatives trading (Index futures)
2001 BSE commences derivatives trading
Primary and Secondary Markets
An Issuer/Company enters the Primary markets to raise capital. They issues new securities in Exchange for cash from an investor (buyer). If the Issuer is selling securities for the first time, these are referred to as Initial Public Offers (IPO's). Summing up, Primary Market is the means by which companies float shares to the general public in an Initial Public Offering to raise capital.
Eg. If the promoters of a private company, say XYZ makes its shares available to investors, company XYZ is said to have entered the primary market.
Once new securities have been sold in the Primary Market, an efficient mechanism must exist for their resale, if investors are to view securities as attractive opportunities. Secondary Market transactions are referred to those transactions where one investor buys shares from another investor at the prevailing market price or at whatever price both the buyer and seller agree upon. The Secondary Market or the Stock Exchanges are regulated by the regulatory authority. In India, the Secondary and Primary Markets are governed by the Security and Exchange Board of India (SEBI).
eg. If one of the investors who had invested in the shares of company XYZ sold it to another at an agreed upon price, a Secondary Market transaction is said to have taken place. Normally investors transact in securities using an intermediary such as a broker who facilitates the process.
Introduction to SEBI
The Government of India established the Securities and Exchange Board of India, the regulatory body of stock markets in 1988. Within a short period of time, SEBI became an autonomous body through the SEBI Act passed in 1992, with defined responsibilities that cover both development & regulation of the market while also giving the board independent powers. Comprehensive regulatory measures introduced by SEBI ensured that end investors benefited from safe and transparent dealings in securities.
The basic objectives of the Board were identified as:
To protect the interests of investors in securities
To promote the development of Securities Market
To regulate the Securities Market
SEBI has contributed to the improvement of the Securities Market by introducing measures like capitalization requirements, margining and establishment of clearing corporations that reduced the risk of credit.
Today, the board continues on its two-fold mission of integrating the Securities Market at the National level and also diversifying the trading products to increase the number of traders (including banks, financial institutions, insurance companies, Mutual Funds, primary dealers etc) transacting through the Exchanges. In this context the introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD has been a real landmark.
What are Stock Exchanges?
A Stock Exchange is a place that provides facilities to stock brokers to trade company stocks and other securities. A stock may be bought or sold only if it is listed on an exchange. Thus it is the meeting place of the stock buyers and sellers. India's premier Stock Exchanges are the Bombay Stock Exchange and the National Stock Exchange.
Getting Familiar with Market Related Concepts
Once you enter the Stock market, you will frequently come across terms like Market Capitalization, Small-Cap Stocks, Mid-Cap Stocks and Large-Cap Stocks. In this section you will get an understanding of what these terms mean in the context of stock markets.
Let us first understand MARKET CAPITALIZATION
"Cap" is short for capitalization, the market value of a stock, indicating the size of the stock available.
Calculating a stock's capitalization
Market Capitalization = Market Price of the stock x The number of the stock's outstanding* shares
*Outstanding means the shares held by the public
For example, if Stock A has a Current Market Price of Rs 20 per share, and there are 1,00,000 shares in the hands of public investors, then Stock A has a capitalization of 20,00,000.
The company's capitalization is an effective parameter to group corporate stocks.
In the US, mid-cap shares are those stocks that have a market capitalization ranging from Rs 9,000 crore to Rs 45,000 crore. In India, these shares would be classified as large-cap shares. Thus, classification of shares into large-cap, mid-cap, small-cap is made on the basis of the relative size of the market in that particular country. The total market capitalization of US markets is $15 trillion. In India, the market capitalization of listed companies is around $600bn.
The stocks of small companies that have the potential to grow rapidly are classified as small-cap stocks. These stocks are the best option for an investor who wishes to generate significant gains in the long run; as long he does not require current dividends and can withstand price volatility. Generally companies that have a market Capitalization in the range of upto 250 Corores are small cap stocks.
As many of these companies are relatively new, it is difficult to predict how they will perform in the market. Being small enterprises, growth spurts dramatically affect their values and revenues, sending prices soaring.
On the other hand, the stocks of these companies tend to be volatile and may decline dramatically.
Most Initial Public Offerings are for small-cap companies, although these days large companies do tend to source the capital markets for expansion plans. Aggressive mutual funds are also enthusiastic about adding small-cap stocks in their portfolios. Because they have the advantage of being highly growth oriented, small-cap stocks can forego paying dividends to investors, which enables the profits earned to be reinvested for future growth.
Mid-cap stocks are typically stocks of medium-sized companies. These are stocks of well-known companies, recognized as seasoned players in the market. They offer you the twin advantages of acquiring stocks with good growth potential as well as the stability of a larger company. Generally companies that have a market Capitalization in the range of 250-4000 crores are mid cap stocks.
Mid-cap stocks also include baby blue chips; companies that show steady growth backed by a good track record. They are like blue-chip stocks (which are large-cap stocks) but lack their size. These stocks tend to grow well over the long term.
Stocks of the largest companies (many being blue chip firms) in the market such as Tata, Reliance, ICICI are classified as large-cap stocks. Being established enterprises, they have at their disposal large reserves of cash to exploit new business opportunities.
The sheer volume of large-cap stocks does not let them grow as rapidly as smaller capitalized companies and the smaller stocks tend to outperform them over time. Investors, however gain the advantages of reaping relatively higher dividends compared to small- and mid-cap stocks while also ensuring the long-term preservation of their capital.
What drives bull and bear markets?
The uses of "Bull" and "bear" to describe markets have been derived from the manner in which each of these animals attacks its opponents. A bull thrusts its horns up into the air, and a bear swipes its paws down. These actions are metaphors for the movement of a market: if the trend is up, it is considered a Bull market. And if the trend is down, it is considered a Bear market.
The supply and demand for securities largely determine whether the market is in the Bull or Bear phase. Forces like investor psychology, government involvement in the economy and changes in economic activity also drive the market up or down. These combine to make investors bid higher or lower prices for stocks.
How can you qualify the market as bull or bear?
Bull and Bear markets signify relatively long-term movements of significant proportion. Hence, these runs can be gauged only when the market has been moving in its current direction (by about 20% of its value) for a sustained period. One does not consider small, short-term movements, lasting days, as they may only indicate corrections or short-lived movements.
What are stock symbols?
A stock symbol is a unique code that is given to all participating companies in securities trading. Once you know the stock code/symbol of the company (sometimes referred to as a ticker symbol) you can easily obtain information about the company. This is important, as a wise investor will always do a financial analysis before purchasing a stock.For ex- tcs stands for Tata Consultancy Services Infy stands for Infosys.
Note :- While placing orders with Kotaksecurities.com you need to type in just the first three alphabets of the company and our site will display all possible combinations, from which you may select the stock that you wish to invest in.
Where do I find stock related information?
What are rolling settlements?
Let us understand Rolling Settlements with an example.Supposing your friend agrees to buy a book for you from a bookshop, you will have to pay him for it eventually. Similarly, after you have bought or sold shares through your broker, the trade has to be settled. Meaning, the buyer has to receive his shares and the seller has to receive his money. Settlement is just the process whereby payment is made by all those who have made purchases and shares are delivered by all those who have made sales.
A Rolling Settlement implies that all trades have to settled by the end of the day. Hence the entire transaction, where the buyer has to make payments for securities purchased and seller has to deliver the securities sold, have to completed in a day.In India, we have adopted the T+2 settlement cycle, which means that a transaction entered into on Day 1 has to be settled on the Day 1 + 2 working days, when funds pay in or securities pay out takes place.'T+2" here, refers to Today + 2 working days.
For instance, trades taking place on Monday are settled on Wednesday, Tuesday's trades settled on Thursday and so on.Hence, a settlement cycle is the period within which the settlement is made.For arriving at the settlement day, all intervening holidays -- bank holidays, Exchange holidays, Saturdays and Sundays are excluded. From a settlement cycle taking a week , the Exchanges have now moved to a faster and efficient mode of settling trades within T+2 Days.
What is the meaning of the term selling short?
An investor sells short when he anticipates that the price of the shorted stock will fall from the existing price. He borrows a share and sells it. As the share price dips, he buys the same share at a lower price and returns it back, while pocketing a profit in the bargain. An adage that describes short selling is ("selling high and buying low'.) Selling Short (Shorting) is an effective tool for traders as it allows us to profit from declining stock and index prices.
A definition of "Selling Short"
Selling short implies establishing a market position by selling a security one does not own, in anticipation that the price of the security will fall.
For eg. Trader anticipates stock ABC will declineTrader enters order to SELL 2000 shares of ABC at market price and later buys the 2000 shares of ABC at a much-reduced price. The difference in the prices of the selling and buying is his profit. However if the share prices increase after he has sold at a reduced price earlier, then he ends up with a loss. Hence Shortselling is something that is speculatory to a certain extent and is done in anticipation of quick profits.
What is margin trading?
Margin trading is trading with borrowed funds/securities. It is almost like buying securities on credit.
Margin trading can lead to greater returns, but can also be very risky. While it lets you actively seize market opportunities it also subjects you to a number of unique risks such as interest payments charged for the borrowed money.
What are Circuit filters & trading bands?
In order to check the volatility of shares, SEBI has come up with the concept of Circuit Filters. Under this, Sebi has specified the fixed price bands for different securities within which they can move on a given day.
Recently, in a bid to check the rampant price manipulation in small-cap stocks (known as penny stocks), stock exchanges reduced the circuit filter maximum permissible rise in prices in a day to 5 per cent.Earlier, stocks were allowed to rise up to 20 per cent in a session.
The NSE has also reduced the circuit filter in all the stocks, which are traded on a trade-to-trade basis to 5 per cent. As the closing price on BSE and NSE can be significantly different, this means that the circuit limit for a share on BSE and NSE can be different.
What is Badla financing?
As the term itself signifies, 'Badla' means 'something in return'. Badla is the charge, which the investor pays for carrying forward his position. This hedge tool lets the investor take a position in a scrip without actually taking delivery of the stock, thus carrying forward his position on the payment of small margin. The badla system of transactions has been in practice for several decades in the Stock Exchange, Mumbai and serves 3 needs of any stock exchange:
A) Quasi-hedging:If an investor feels that the price of a particular share is expected to go up or down, without giving or taking the delivery he can participate in the possible volatility of the share.
B) Stock lending:If a stock lender wishes to short sell without owning the underlying security, he employs the badla system and lends his stock for a charge.
C) Financing mechanism:If he wishes to buy the share without paying the full consideration, the financier steps into the CF system and provides the finance to fund the purchase The scheme is known as "Vyaj Badla" or "Badla" financing.
For example, X has bought a stock and does not have the funds to take delivery he can arrange a financier through this carrying-forward mechanism. The financier would make the payment at the prevailing market rate and would take delivery of the shares on X's behalf. X will only have to pay interest on the funds he has borrowed. Vis-à-vis, if you have a sale position and do not have the shares to deliver, you can still arrange through the stock exchange for a lender of securities. An investor can either take the services of a badla financier or can assume the role of a badla financier and lend either his money or securities.
How the Badla system works?
On every Saturday, a CF system session is held at the BSE. The scrips in which there are outstanding positions are listed along with the quantities outstanding. The CF rates are determined depending on the demand and supply of money. There is more demand for funds when the market is over bought, and consequently the CF rates tend to be high.
However, when the market is oversold the CF rates are low or even reverse i.e. there is a demand for stocks and the person who is ready to lend stocks gets a return for the same.
The scrips that have been put in the Carry Forward list are all 'A' group scrips, which have a good dividend paying record, high liquidity and are actively traded. The scrips are not specified in advance, as it then gets difficult to get maximum return. The Trade Guarantee Fund of BSE guarantees all transactions; hence, there is virtually no risk to the badla financier except for broker defaults. Even if the broker through whom you have invested money in badla financing defaults, the title of the shares would remain with you and the shares would be lying with the "Clearing house". However, the risk of volatility of the scrip will have to be borne by the investor.
What is Insider Trading?
In your dealings with the stock world, you will often come across the term 'insider trading'. In simple words, the meaning of insider trading is 'the trading of shares based on knowledge not available to the rest of the world.
Insider trading has 2 connotations.
Corporate personnel of a company buying and selling stock in their own company. When corporate insiders trade in their own securities, they must report their trades to the exchange. Illegal insider trading refers to buying or selling a security after receiving 'tips' of confidential securities information. Thus it is considered as a breach of confidence while in possession of non-public information about the company.
Examples of insider trading·
Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;·
Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;·
Government employees who learned of such information because of their employment by the government; and·Other persons who misappropriated, and took advantage of, confidential information from their employers.
What are the various types of the risks once I start trading?
This is the risk of investing in the stock market in general. It refers to a chance that a securitys value might decline. Although a particular company may be doing poorly, the value of its stock can go up because the stock market value is collectively going up. Conversely, your company may be doing very well, but the value of the stock might drop because of negative factors inflation, rising interest rates, political instability etc that are effecting the whole market. All stocks are Affecting by market risk.
This is risk that affects all companies in a certain industry. For eg. Utility companies, are often viewed as relatively low in risk because the utility industry is stable and operates in a predictable environment with relatively little change. In contrast, internet and other technology industries are usually viewed as high in risk because the industry is changing so quickly and unpredictably. The dotcom bubble burst in the 90s affected the valuation of all stocks in that industry.All stocks within an industry are subject to industry risk.
Virtually every company is subject to some sort of regulation. It refers to the risk that the government will pass new laws or implement new regulations, which will dramatically affect a business.
These are the risks unique to an individual company. It refers to the uncertainty regarding the organizations ability to perform business or provide service Products, strategies, management, labor force, market share, etc.,Which are among the key factors investors consider in evaluating the value of a specific company.
What is an annual report and why is it useful to investors?
An annual report provides a company's shareholders with information about its operations. This is an obligation stipulated by law. This is extremely beneficial to investors because it helps make informed decisions.The report tells you how well the company is doing while also forecasting its future earnings and dividends. The Chairman's letter in the report also profiles the company's future goals.
Inside the Annual Report
Here is what comprises an annual report:
* A letter from the chairman on the high points of business in the past year with predictions for the next year.
* The company philosophy: A section that describes the principles and ethics that govern a company's business.
* An extensive report on each section of operations within the company, describing the company's services or the products.
Financial information that includes the profit and loss (P&L) statements and a balance sheet. Depending on its income and expenses, the company will either make profits or show losses for a year. The balance sheet describes assets and liabilities and compares them to the previous year. The footnotes will also give you reveal important information, as they discuss current or pending lawsuits or government regulations that may impact the company operations.
* An auditor's letter in the annual report confirms that the information provided in the report is accurate and has been certified by independent accountants.
How do I obtain an Annual Report?
Annual reports are mailed automatically to all shareholders on record. If you wish to obtain the annual report about a company in which you do not own shares, you can call its public relations (or shareholder relations) department. You may also look at the company web site, or search the Internet; as there are several sources on the Internet providing information on public companies.
All publicly listed companies are required to submit the financial reports available in the public domain as per SEBI regulations.
What are quarterly and other financial reports?
Besides the annual report, companies provide several other financial reports such as a quarterly reports (issued every three months) and statistical supplements. These however are not as comprehensive as the annual report of the company.
Quarterly reports are very similar to the annual reports except they are issued every three months and are less comprehensive. They may be obtained in the same way as an annual report.
What are Company Earnings?
Earnings are a company's net profit. It is the surplus left with the company after it has cleared all its expenses, i.e. Money paid to employees, utility bills, costs of production and other operating expenses The manner in which a company makes its earnings, is defined by the very nature of its business.
For eg., a cement manufacturer produces cement for sale to its customers.
Two sources of company earnings are:
Ø Income from sales of goods or services
Ø Income from investment.
Investments generate income for businesses by way of either interest on loans, dividends from other businesses, or gains on the sale of investment property.Thus, company earnings are the sum of income from sales or investment left after the company has met its obligations.
Why are Earnings important to you as an investor?
As an investor who holds shares of the company, you have part ownership of company.When you invest in a company's shares, you become a 'part owner' of the company and you get to share a part of the company's profit as dividend. Thus, if the company does well and earns more profit, you in turn to well. If the company reinvents its earnings towards future growth, you are assured of higher dividends in the future.
Meanwhile, if you lend money to the company by investing in its bonds, the company uses part of its earnings to repay interest and principle on the bonds. The more earnings the company has, the more secure you can be that the company will be able to make your interest payments. So, company earnings are important to you because you make money when the business you invest in, makes money.
How do you use earnings information to make an investment decision?
Your investment goals determine how you use information about company earnings. If you are an income investor, interested in earning immediate income from your investments, you probably want to invest in a company that is paying dividends. If you have a long-term investment strategy, dividends may not be as important to you. The "financials" indicate whether a company is oriented for income, growth, or a bit of both. By comparing the financials for different companies in the same industry, you can find characteristics best suited to your investment goals.
A convenient way to compare companies is through Earnings per share (EPS). EPS represents the net profit divided by the number of outstanding shares of stock.
When you compare the EPS of different companies, be sure to consider the following:
Ø Companies with higher earnings are stronger than companies with lower earnings.
Ø Companies that reinvest their earnings, may pay low or no dividends but may be poised for growth.
Ø Companies with lower earnings, and higher research and development costs, may be on the brink of either a breakthrough or a disaster, making them a risky proposition.
Ø Companies with higher earnings, lower costs and lower shareholder equity, might go in for a merger.
How do I use Fundamentals to make an investment decision?
Fundamental Analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. But this research can never accurately predict how the company will perform in the stock market. It can however be used as a good comparative framework to know which company will be a better investment choice.
As an investor, you are interested in a corporation's earnings because earnings assure higher dividends and potential for further growth. You can use profitability ratios to compare earnings for prospective investments. These are measures of performance showing how much the firm is earning compared to its sales, assets or equity.
You can quickly see the difference in profitability between two companies by comparing the profitability ratios of each. Let us see how ratio analysis works.
What is Ratio Analysis?
The ratio analysis technique is also called cross-sectional analysis, providing you with important information about a company's financial strength. Cross-sectional analysis compares financial ratios of several companies from the same industry and enables you to deduce success, failure or progress of any business. Thus, a financial ratio measures a company's performance in a specific area and guides your judgment regarding which company is a better investment option. Some of the important ratios that an investor must know are:
1) Price-Earnings Ratio((P-E ratio):
It is a ratio obtained by dividing the price of a share of stock by Earnings per share (EPS) for a 12-month period.
2) EPS (Earnings Per Share):
It is that portion of a company's net income, which corresponds to each share of that company's common stock which is issued and outstanding. EPS gives an indication of the profitability of a company.
It is calculated using the formula:
EPS = Net Income-Dividends on Preferred Stock / Average Outstanding Shares
3) Current Ratio:
Companies need a surplus supply of current assets in order to meet their current liabilities. They generally pay their interest payments and other short-term debts with current assets. If a company has only illiquid assets, it may not be able to make payments on their debts. It is a type of Liquidity ratio.
Current Ratio = Current Assets / Current Liabilities
Traditionally, leverage is related to the relative proportions of debt and equity, which fund a venture. The higher the proportion of debt, the more leverage.It is a ratio that measures a company's capital structure, indicating how a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of equity and debt? The answers to these questions are of great importance to investors.
Leverage= Long Term Debt / Total Equity
A firm that finances its assets with a high percentage of debt is risking bankruptcy, higher borrowing costs and decreased financial flexibility; if its performance cannot help fulfill its debt payments. If a company is highly leveraged, it is also possible that lender's may shy away from providing further debt financing fearing the viability of their investment.
The optimal capital structure for a company you invest in, depends on which type of investor you are. A bondholder would prefer a company with very little debt financing because of it lowers the risk of him losing his money.
When a firm becomes over leveraged, bankruptcy can result.
Shareholders' equity is calculated as the value of a company's assets less the value of its liabilities. It is the value of a business to its owners, after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners invested, plus any profits that the company generates.
Bankruptcy is a legal mechanism that allows creditors to assume control of a firm when it can no longer has the ability to meet its financial obligations. Both stock and bond fear bankruptcy. Generally, the firm's assets are sold in order to pay off creditors to the largest extent possible.
When bankruptcy occurs, stockholders of a corporation can only lose the amount they have invested in the bankrupt company. This is called Limited Liability. If a firm's liabilities exceed the liquidation value of their assets, (the value of assets converted into cash), creditors also stand to lose money on their investments.
Understanding the Balance Sheet
The balance sheet is one of the most important financial statements of a company. The logic behind producing a balance sheet is to ensure that the accounts are always in balance and all the company funds can be accounted for. It is reported to investors at least once a year. You may also receive quarterly, semiannually or monthly balance sheets.
The contents of a balance sheet include:
What the company owns (its assets)What it owes (its liabilities)The value of the business to its stockholders (the shareholders' equity).
Why should the Balance Sheet be important to you?
As an investor you need to ensure that the company you have invested in, has good potential for future growth and will yield good returns. The balance sheet helps you get answers to questions like:
· Will the firm meet its financial obligations?
· What amount of funds have already been invested in this company?
· Is the company overly indebted?
· What are the different assets that the company has purchased with its financing?
These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides a diligent investor with many clues to a firm's future performance.
What are Assets?
Assets are any items of economic value owned by a corporation that can be converted into cash.
Types of Assets:
Current assets are assets that are usually converted to cash within one year. Bondholders and other creditors closely monitor a firm's current assets since interest payments are generally made from current assets. Also incase the company goes bankrupt, assets can be easily liquidated into cash and help prevent loss of your investments. Current assets are important to most companies, as they are a source of funds for day-to-day operations. It is thus evident, that the more current assets a company owns, the better it is performing.
Cash equivalents are not cash but can be converted into cash so easily that they are considered equal to cash. Cash equivalents are generally highly liquid, short-term and very safe investments.
Accounts receivable is the money customers (individuals or corporations) owe the firm in exchange for goods or services that have been delivered or used but not yet paid for.As more and more business is being done today with credit instead of cash, this item is a significant component of the balance sheet. Accounts receivable is however recorded as an asset on the balance sheet as it represents a legal obligation for the customer to remit cash.
A firms inventory is the stock of materials used to manufacture their products and the products themselves for future sale. A manufacturing company will often have three different types of inventory: raw materials, works-in-process, and finished goods. A retail firm's inventory generally will consist only of products purchased that are still to be stored. Inventory is recorded as an asset on a company's balance sheet.
Long-term assets are grouped into several categories like:
A long-term, tangible asset held for business use and not expected to be converted to cash in the current or upcoming fiscal year, such as manufacturing equipment, real estate, and furniture.
Fixed assets are long-term, tangible assets held for business use and will not be converted into cash in the current or upcoming year.
Eg. Items such as equipment, buildings, production plants and property. On the balance sheet, these are valued at their cost. As the value of the asset declines over the years, depreciation is subtracted from all, except land. Fixed assets are very important to a company because they represent long-term investments that will not be liquidated soon and can facilitate the companys earnings.
Depreciation gives you an estimate of the decrease in the value of an asset, caused by 'wear and tear' or obsolence. It appears in the balance sheet as a deduction from the original value of the fixed assets; as the value of the fixed asset decreases due to wear and tear.
Intangible assets are non-physical assets such as copyrights, franchises and patents. Being intangible, it becomes difficult to estimate their value. Often there is no ready market for them. Sometimes however, an intangible asset can be the most valuable asset a company possesses.
What are Liabilities?
Liabilities are a company's debt to outside parties. They represent rights of others to expect money or services of the company. A company that has too many liabilities may be in danger of going bankrupt. Eg. Bank loans, debts to suppliers and debts to its employees. On the balance sheet, liabilities are generally broken down into Current Liabilities and Long-Term Liabilities.
Types of Liabilities:
Current liabilities are debts currently owed for taxes, salaries, interest, accounts payable* and notes payable, that are due within one year.
A company is considered to have good financial strength when current assets exceed current liabilities.
Accounts payable is one of a series of accounting transactions covering payments to suppliers whom the company owes money for goods and services. Therefore, you will often see accounts payable on most balance sheets.
Long-term debt is a long-term loan, for a period greater than one year. These debts are often paid in installments. If this is the case, the portion to be paid off in the current year is considered a current liability.
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