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.
Top Australian Brokers
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:
• 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
Cash and Cash Equivalents
Current Tax Asset
|Total Current Assets||1,460,802||687,662|
|Non – Current Assets
Other Non – Current Assets
Explotation and Evaluation Assets
Oil and Gas Assets
Other Property, Plant and Equipament
Deferred Tax Assets
|Total Non – Current Assets||1,616,588||1,317,795|
Current Tax Liabilities
|Total Current Liabilities||265,313||196,984|
|Non – Current Liabilities
Deferred Tax Liabilities
|Total Non – Current Liabilities||218,896||215,246|
|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.