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Ratio Analysis is one of the most widely used investment tools all over the globe.  With the exception of the hard-core technical analyst types, most investors rely on financial ratios of all kinds to evaluate shares.  It is the cornerstone of fundamental analysis.

Even the most recent newcomers to share market investing quickly discover the ultimate source of all ratios are the reported financial statements of the shares in question – most noticeably the balance sheet (or statement of financial position), the income statement (or statement of comprehensive income), and finally the cash flow statement.

Because so many financial websites in the global investing marketplace include numerous ratios, not all retail investors follow the advice of some of history’s greatest investors like Benjamin Graham, Peter Lynch, and Warren Buffet, to dig into those financial statements and annual reports on your own to learn what you need to know to make an intelligent investment.  This is all too often true, even when the ratios alone do provide a complete picture.

In a previous column, we used Graham’s seven tests for defensive shares to look at three potential share investments in the Australian energy sector -OSH (Oil Shares Limited), STO (Santos Limited), and WPL (Woodside Petroleum).  All three had issues needing further research.  Today we are going to begin a journey of exploration and discovery into the actual annual report and accompanying financial statements of one of those companies – Oil Shares Limited.

Some financial websites like Yahoo Finance Australia have derivative versions of the balance sheet, income statement, and cash flow statement on their websites.  However, intelligent investors know those versions are no substitute for going to the original source – the company’s annual report.  While it is certainly more convenient to scan columns of numbers on your favorite site, you miss the opportunity you get to “read between the lines” by going to the source.

Sites like thebull.com.au include links to the company website where you can find recent annual reports in the Investor Section of the site.  To understand why this is necessary for serious retail investors, you have to understand the nature of annual reports and financial statements.

Think of your own professional resume.  The intent is to convey to the reader information about you that shows your qualifications and accomplishments in the best possible light.  While few people include absolute falsehoods on their resumes, everyone goes to great pains to polish up each bit of information so it shines like sterling silver.

So it is with a company’s financial reporting.  Their accountants do their utmost to present the financial picture in the best possible light.  However, they include a section of accounting notes that accompanies each of the three financial statements.  Here they explain the accounting principles they followed to derive the displayed numerical value.  Rigorous investors see the accounting notes section as the place to mine for the gold needed by all investors – information.  And you won’t find accounting notes in any financial website anywhere in the world – only at the original source.

This week we will start with the Statement of Financial Position, or balance sheet, for OSH.  There are three core components of any balance sheet:

•    Assets
•    Liabilities
•    Ownership Equity

By definition, the company’s liabilities plus the ownership (or shareholder) equity must be in balance, or be equal to, the sum of its assets.  Privately held companies also issue stock, which is not available to the public.  Should a private company decide to cease operation for any reason, all that it owns – its assets – would be sold to first pay off all that it owes with the remaining proceeds going to the owners according to their equity position.

A publicly traded company like OSH has the same information on its statement of financial position – assets, liabilities, and shareholder equity.  Here is the balance sheet for OSH released in March 2010 for FY 2009:

Oil Shares Limited
Statement of Financial Positions
As At 31 December 2009
   
Note
2009
US$’000
2008
US$’000
Current Assets
Cash and Cash Equivalents
Receivables
Inventories
Current Tax Asset
Other Assets
 
21 (a)
9     
10     
 
11     
 
1,288,077
108,783
59,518

4,424

 
534,928
96,132
52,854
 
3,748
Total Current Assets    1,460,802 687,662
Non – Current Assets
Receivables
Other Non – Current Assets
Explotation and Evaluation Assets
Oil and Gas Assets
Other Property, Plant and Equipament
Investments
Deferred Tax Assets

 

9     
11     
12     
13     
14     
15     
16     

 
416
1,206
808,318
638,026
76,220
 
92,402
 
42,848
1,651
516,256
588,133
80,006
 
88,901
Total Non – Current Assets   1,616,588 1,317,795
Total Assets   3,077,390 2,005,457
Current Liabilities
Payables
Provisions
Current Tax Liabilities
 
17     
18     
 
204,119
11,963
49,231
 
169,580
12,276
15,128
Total Current Liabilities   265,313 196,984
Non – Current Liabilities
Provisions
Deferred Tax Liabilities
 
18
19
 
122,152
965,744
 
114,621
100,625
Total Non – Current Liabilities   218,896 215,246
Total Liabilities   484,209 412,230
Net Assets   2,593,181 1,593,227
Shareholders’ Equity
Share Capital
Reserves
Retained Profits
 
20
20
 
 
1,550,213
5,447
1,037,521
 
620,491
1,514
971,122
Total Shareholders’ Equity   2,593,181  1,549,243

 

Even without the use of ratios, there are several numbers here that begin to tell the story you need to hear – what is going on with this company.  First, notice the company’s cash position – about 1.3 billion.  The figures are in US dollars, and the notation 000 in the header column simply means add three zeros to each value on the statement.  $1,288,077 is in actuality $1,288,077,000.  As you know, numbers in isolation have less value than numbers you can compare.  Here we see OSH has substantially increased its cash position from year-end 2008 to year-end 2009.

Assets are broken down into current assets – those the company expects to convert within the 1-year time of the report – and non-current assets – those that will not convert and will carry over to the next report.  

Liabilities also are categorized by time – current liabilities are bills due within the year while non-current liabilities extend beyond the reporting period.  A quick glance at the numbers tells us Oil Search has not seen a significant increase in total liabilities, but does show a fairly substantial increase in total assets.

Shareholder equity is another impressive number on first glance – a one billion dollar increase year over year.  

The “balance” comes into play when you add total liabilities of 484,209 and shareholder equity of 2,593,181 to get a result of 3,077,930 – which matches total assets.  

There are a number of telling comparisons one could make within a balance sheet.  One such comparison is total current assets to total current liabilities.  OSH current asset base of 1,460,802,000 exceeds its current bills of 484,209,000 about three times.  This is how the Current Ratio of 3.01 you would see on a financial website is calculated.

Statements of Financial Position do not exist in isolation.  They need to be examined in conjunction with the Statement of Cash Flows and the Income Statement, which we will do next week.