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How to analyze the balance sheets of companies in Nepal|Meaning of equity and Margin of Safety

Do you want to learn the ways of analyzing the balance sheets of companies in Nepal? Also, Do you yawn every time you hear economic jargon’s like assets and liabilities? Trust me, you are not alone. Sometimes I think People in finance invented these words just to confuse ordinary people. Don’t worry, after you read this post, you will clearly understand what the meaning of assets, liabilities, and equity of a business is. You will also be able to tell if someone is trying to sell you a bad business. And actually, calculate the risk of buying a business in Nepal. I promise you it’s nothing but basic subtraction and addition.

Let’s say you recently decided to buy a business from a friend. How can you tell if it’s a good investment? My last blog post on value investing was extensive, and I talked about a lot of stuff. But here I want to keep things specific and narrow. From this article, you will be able to understand:

Importance of a Balance sheet

finanancial statements and balance sheets

Any company or most companies has three official papers (financial statements) that have to be accounted for. Namely, its the Income Statement, Balance Sheet and the Cash Flow statement. All of these are very important and give different information about a business. But here I want to talk mostly about one of these statements, which is the balance sheet. In the future, I will be writing an in-depth article on all three financial statements and ways to properly analyze them. But for now, let us focus specifically on balance sheets that contain information about the assets and liabilities of a particular business.

But why, you may ask? Why focus on assets and liabilities? The first reason is that it will make it easy for you to understand the essence of a balance sheet (to define the Margin of safety). And the next reason is looking at these specific values in a balance sheet, which will help you to quickly calculate the amount of risk you will be taking when buying into a business (Yes, that involves stocks).

Continuing from the last article

Let us continue from where we left off in the previous post (Which is a must-read if you want to understand this one) and look at the example of the fruit business in more detail. In the last article, we came up with a few arbitrary numbers. Let’s use those numbers to define the equity of that business. Let’s say the owner wants to sell the business for 1,00,000. Then as we discussed in that post, you will end up getting a 20% return on your investments if nothing changes. So In this case, 1,00,000 is the market price for the business. i.e.the amount for which the owner is willing to sell the business.

So, do you think it will be a good investment? 20% on paper looks very good, doesn’t it? But what looks good on paper might not always be the reality. That 20% is only possible if nothing changes when you acquire the business. So, how can you tell if the investment that you are about to make is a good investment? For this, you have to look at the balance sheet of the company.

Equity of a business

calculate the risk of buying a business in Nepal

An Equity of a business is the value you obtain after subtracting the total liabilities from the total assets. Hence the equity of a business is basically the amount you will receive if you liquidate the business (i.e. if you sell everything worth selling like fruits, juice machine, land e.t.c). As you can see in the assets and liabilities section, I have listed a few items twice. For, e.g. The juice machine; it merely means that the total worth of the juice machine is 12,000 (asset), but the owner has yet to pay the 9000 (Liabilities) that he owes to the bank or the person that lent him the money (And the same goes for other double entries).

What does the Book value of a share mean?

When you divide the equity into individual shares. Then the value you get for one share of that company is called the book value of that share. (More on this in the next post where I will be writing about stocks in more detail).

Coming up with your own personal equity

I think these ideas will make a perfect sense if you sit down and note all of your personal assets and liabilities. In assets column, it could be the cash you have at hand, your income, things you own (Laptops, guitar, camera (for what they are currently worth) e.t.c.). Similarly, in the liabilities column, you can add things like a debt you may need to pay to one of your friends (or many), the cost of transportation (or cost of petrol if you have a bike) e.t.c.

Trust me, it’s a fun experiment. And probably a good first step towards personal finance. This will help you to get an idea of your spending habits, the amount of risk you can take on investments, and so on.

The Margin of safety and calculate the risk of buying a business in Nepal

The Margin of safety is simply the risk that is involved in acquiring a business or a stock. Or, simply it is the difference between the equity of a company (equity=book value for individual stocks), and it’s market price. This is why looking at the balance sheet of a company is so important. It gives you the actual worth of a company (don’t confuse the worth of a company with its intrinsic value, these two ideas are entirely different). The market price of the company (the amount for which the owner wants to sell) is only 10% of the total equity (As you can see in the figure above).

So, the question then you have to ask yourself is? for 20% of the yearly return (which is if the business stays the same when you take over, which is highly unlikely in the long run if you don’t have any experience with the business itself) is the market price fair? If your answer is yes, then go ahead and buy the business, but understand that with only an equity of 10,000 you are taking a lot of risks (i.e. the Margin of the safety of the business is low).

If the sales go down, you may be forced to sell the entire business in which case you will be left with 10,000 Rs. Whereas, if the answer is no, then you have two options; Re-negotiate or look somewhere else. (Same goes for stocks)

What about the 20,000 in profit that the owner gets

As we discussed in the last article, when the owner receives the 20,000 he has two options; he/she can pay themselves or (smart choice) invest it back into the business (retained as equity to the business). If the owner does decide to invest the money back into the business, then the total equity of the business will be 30% of the asking price. And as we have discussed above, it will help raise the Margin of safety for acquiring that business.

Summary

  1. Balance sheets are used to calculate the Margin of safety for acquiring a business
  2. Equity of the business is calculated as Total Assets – Liabilities
  3. Coming up with your own personal equity is a fun experiment
  4. The Margin of safety is calculated as (a Market price or Asking price) – Total Equity

Last articles on Value Investing

Want to more?

If you find yourself in a curious state of mind and want to look at balance sheets of companies here in Nepal, then go to https://www.sharesansar.com/ and search for the company you want to research. Go to the bottom left of the page and under financials, you will be able to choose among different financial statements.

For more research: you should check out https://www.theinvestorspodcast.com/ as I am sharing the ideas I learned from his videos. Most of the ideas for these blog articles stem from his explanation of the concept.

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