Sunday, August 30, 2020

The Accounting Equation And How It Helps In Your Fundamental Analysis

Those who had studied accounting or have had an accounting subject back in school would have encountered the accounting equation, which is:

Assets = Liabilities + (Owners’ / Shareholders’) Equity

Or:

A = L + E

For the uninitiated, the accounting equation shows that a company’s assets are made up of debt (liabilities) and shares issued to shareholders (equity). The equation forms the basis of the double entry accounting system which is universally used by accountants worldwide.

The practical application of this equation is shown in a balance sheet, which is one of the three financial statements reported by companies. Here is an example of the A = L + E in real life:

Fig.1: Balance Sheet (excerpted from Singtel 2019 Annual Report, p139)

From Figure 1, you can see that 48,914.1 (A) is equal to 19,105.1 (L) plus 29,807.7 (E).

So how does it help in my fundamental analysis (FA)?

As you can see from the balance sheet, there are many details and things that made up the assets, liabilities and equity parts. For this post I will not go into their intricacies, but instead I will provide an overview with a few pointers and nutshell explanations, which could be useful for people who do not know where and how to start their FA.

Ratios

Two ratios can be derived with this accounting equation alone, and that is debt-to-asset and debt-to-equity ratios, which are L / A and L / E respectively. A high number in both ratios indicates that the liabilities portion is large, especially so when the L / A ratio is closer to 1. For L / E, it is common for some companies to have liabilities larger than the equity portion, depending on their sector and industry.

On a related note, you can roughly tell the constituents of the assets of the company by just looking at the liabilities and equity numbers. Still, a thorough FA is required to look deeper into the nature of these components so as to form a better opinion of the whole scheme of things.

Calculating Net Asset Value

From the accounting equation, you can also see how the net asset value (NAV) of a company share can be calculated. By knowing the number of shares outstanding (which can be found in the company’s annual report), NAV is simply:

A = L + E

E = A – L

NAV = (A – L) / number of shares outstanding

Bear in mind NAV alone may not give a full picture of the true value of a company share, and other valuation methods may have to be taken into account, like price-to-earnings, discounted cash flow, etc.

Rights, Bonds, Bank Loans, Perpetual Bonds And Preferential Shares

A company has three main ways of raising additional capital; rights, bonds and bank loans. In the accounting equation, rights are considered equity, while bonds and bank loans form the liabilities part. The addition of rights meant that equity will increase, which translates to having more shares being issued and thus creating a dilution effect, i.e. more “slices” of the company pie are being created. For bonds and bank loans, their additions will increase the liabilities part, and along with it a rise in the debt-to-asset and debt-to-equity ratios.

The tricky part is there are some types of securities that may be considered either as liabilities or equity, depending on how one views them, like for instance perpetual bonds and preferential shares. While conducting FA, there is no hard and fast rule on how to treat such securities, though some prudent investors may treat them as liabilities in their calculations, while the more optimistic ones may take them as equity.