Saturday, May 31, 2008

Analytical Review 101 – Part VI

Balance Sheet – Current Assets

What is a Balance Sheet?
The Balance Sheet shows the position of the company as at the end of the financial year (or as at a specific date). The Balance Sheet contains summary information of all assets and liabilities of the company including its' Intangible Assets, Property, Plant and Equipment, Long Term and Current Assets, Long Term and Current Liabilities and the Shareholders’ Equity. This is noteworthy as it gives us an indicator as to the value or worth of a company.

What do Current Assets represent?
The Current Assets are assets
which is expected to be sold or otherwise used up in the near future, usually within one year. It usually consists of trade receivables, other receivables, inventories and cash & cash equivalents.

1. Trade Receivables
Trade receivables consist of amounts due from customers. These amounts arise because most business gives credit period and limits to their customers. The average credit period given to customers vary depending on the industry they are in.

Usually, the longer the credit period given to customers, the larger trade receivables amounts recorded in the Balance Sheet. Why then should the company give credit periods to its' customers? Wouldn't it be better to have all sales on Cash On Delivery (COD) terms?

This is not possible for most businesses as it is often necessary to give reasonable credit period to customers for the company to secure sales and maintain customer goodwill.

A sudden increase in the trade receivables of a company compared to previous years is not always favorable. It may indicate that the company is relaxing it's credit period to customers’ to secure additional sales. Another possibility may be the company is facing difficulties in recovering the debts owed by its’ customers. Either way, this may result in the company facing cash flow problems, in the long run.

2. Other Receivables
Other receivables usually consist of:
(i) Other deposits, receivables and prepayments;
(ii) Amount due from related companies and subsidiaries; and
(iii) Loans to employees.

By and large, this figure is stable and does not change over the long run. It is usually not significant in our evaluation of the company's value.

However in Nestlé's case, is noteworthy that Nestlé has a long term loan to its' employees amounting to approximately RM22MIL. Note 9.2 states that “Loans to employees are unsecured, interest free and are not expected to be repayable within the next twelve months.

Nestlé employees’ must be happy to enjoy such benefits. However, as a prospective investor, we would like to know what criteria is used to give out loans to it’s’ employees and what are the terms of repayment. If the RM22MIL cash was not loaned out to its' employees, and instead was placed in a Fixed Deposit with 4.5% return per annum, the company would earn an additional RM1MIL interest income.

3. Inventories
Inventories usually consists of raw and packaging materials, work-in-progress, finished goods and spare parts. Manufacturing and distribution groups like Nestlé must keep raw and packaging materials to convert them into finished goods such as ice-cream, powdered milk and drinks. Those raw materials that are still being processed into finished goods at the financial year end, will be classified as work-in-progress. Spare parts are consumables held, often for routine maintenance works and repairs of factory equipment.

Although inventories are assets of the company, it is important to examine this figure. When the inventories in the Balance Sheet is too high compared to previous years or to its’ cost of sales, this may indicates that the company is facing fierce competition and is unable to sell its’ inventories fast enough. Such a situation can easily lead to financial troubles. Large inventory balances may lead to additional warehousing rental, insurance premiums and risk of obsolete, damaged or non-saleable stocks. It is critical to ensure the company maintains stringent inventory management before making your investment decision.

4. Cash and cash equivalents
Cash and cash equivalents are cash, either in the bank or placed under fixed deposits with financial institutions. These are highly liquid instruments with minimal capital risk. Cash is critical to the survival of a company, so always keep a close watch on this balance.

We have appraised and analyzed the major components of the current assets of Nestlé. Some of the important things to watch out for, when reviewing the components in the Current Assets have also been highlighted. My next post will look at the Current Liabilities section.


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