Lenders use qualifying ratios in the underwriting approval procedure for loans. Banks make use of qualifying ratios to identify whether the borrower is eligible for a mortgage or not.
Darvas Box system Every great trader/investor in the history of the markets had a specific method to approach the markets, which eventually led them to create a good fortune, Darvas Box system is one such method. It is a trend following strategy developed by Nicholas Darvas in the 1950s to identify stocks for good upside potential. This is one of the few methods to trade the markets which uses the combination of both the technical analysis and fundamental analysis for a much more refined decision. The fundamentals were used to identify the stocks, and technical analysis was used to time the entry and exits. Who was Nicholas Darvas? Nicholas Darvas was arguably one of the greatest stock traders/investors during 1950s – 1960s, but surprisingly he was a ball dancer by profession and not a professional stock trader. Even while trading and building his fortune, he was on a world tour for his performances in many countries and took up trading as a part-time job. In November 1952 he was invited to a Toronto Nightclub for which he received an unusual proposition of getting paid in shares by the club owners. At that time, all he knew was there is something called stocks which moves up and down in value, that’s it. He accepted the offer and received 6k shares of a Canadian mining company Brilund at 60 cents per share, with the condition that if the stock falls below this price within six months, then the owners would make up the difference. This was the introduction of a professional ball dancer to the stock market. Nicholas Darvas couldn’t perform at the club, so he bought those shares as a gesture. Within two months, Brilund touched $1.9, and his initial investment of $3000 turned to $11400, netting in almost three times of his investment. This triggered a curiosity into the stock markets, and he started to explore trading. Origin of the Darvas Box theory Initially, he was trading on his broker’s recommendation, tips from wealthy businessmen, he even approached some advisory services or any source that he could get his hands on for the tips, but all led him to losses. After losing a lot of money, he decided to develop his own theory, and after a lot of trial and error, his observations and continuous refinements he eventually invented his theory “The Box Theory”. So what exactly is the Box Theory? Fundamentals Analysis As stated earlier, the box theory uses a judicious bend of both the technical and fundamentals. Darvas believed that in order to spot a good stock or even a multibagger, there should be something brewing up in the respective sector as a whole or some major fundamental change in that specific company. Generally, the fundamentals that Darvas used to study were on a broader sector level, and not the company-specific fundamentals. Even for the specific company Darvas used to look from a general perspective like, is the company launching a new product which could be a blockbuster hit. He completely refrained from looking at numbers and financial statements as his initial experiment with ratios and financial statements didn’t yield any good result. To know more on the three financial statements read: Income Statement (P&L) Balance Sheet Cash Flow Statement Technical Analysis Darvas was a big believer in price action and volume of the stock. He believed if some major fundamental changes were to take place in a company, this soon shows up in the stock price and its volume of trading as more people get interested in buying or selling the stock. With his observations here realized by just observing the price action, he can participate in the rally which gets triggered by some major fundamental development without actually knowing about the change. Using the box theory, Darvas used to scan stocks based on rising volume as he needed mass participation in the rally. Also, he only picked up those stocks that were already rising. His theory is all about “buy high, sell higher” instead of the conventional belief of “buy low, sell high”. After the stock satisfies both the parameters of increasing price and volume with major underlying fundamental change, Darvas looks to enter the stock. Good read on momentum trading. How and where to enter? Major part of the box theory is based on entry and exit levels. To enter a stock, Darvas looked for a consolidation phase preceded by a rally. A consolidation phase is the price action wherein the price moves up and down in a tight range, that is, a non-directional move. He would then mark the high and low of the consolidation phase with the horizontal line, essentially making it a box-like structure, hence the name “Box Theory”. The high point is called the ceiling, and low is called the floor. Whenever the stocks break above the ceiling, Darvas would look to buy one tick above the ceiling with one tick below floor as a stop-loss point. Pyramiding Darvas discovered early on, in order to become successful in the market your winning bets should yield much more profit than the loss in the losing bets. This led him to do pyramiding in his winning trade, which is clearly defined in the box theory. Pyramiding means to increase the existing position if the stock is going in the favour, which leads to a much higher profit in the winning trades. According to the box theory, the repetition of the entry criterion is the new signal for adding onto the existing position. In other words, after a position, if the stocks stage the same setup, that is, a consolidation after a rally, then the break above the ceiling of this new box would signal to increase position with the revised stop loss of 1 tick below the new floor. In any case, whenever the stock falls below the current floor, the entire position would we sold off at once. This is the only exit condition in the box theory, and there is no method of booking profit upfront as Darvas believed in holding on to a rising stock. The only way to book profit is to let the stock to take out the revised stop loss.
Key ratios include a number of ratios that are utilised to evaluate the performance of the company compared to other companies. A few key ratios include price-to-earnings, price-to-sales, enterprise value-to-EBITDA etc.
Also known as quantitative factors, market indicators are used for forecasting the future performance of market indices. These are comprised of various formulas and ratios to help investors with their investment or trading decisions.
What is a Balance Sheet? A balance sheet is a financial statement of an enterprise. It is one of the three primary financial statements used in analysing a business or modelling forecast for a business. Other two include the income statement and cash flow statement. It shows the financial positions of business in a given period and includes critical information like the value of assets, liabilities, cash and shareholders’ equity. In this way, a balance sheet enables the information seeker to evaluate the net worth of an enterprise. Good read: Evaluating Financial Statements The balance sheet is a source of information for a number of stakeholders, including investors, creditors, bankers. It helps stakeholders to make efficient decisions and provide transparency. Enterprises are primarily judged on the financial position, which is based on the income statement, balance sheet and cash flow statement. The balance sheet is also referred to as Statement of Financial Position and is applied, along with other financial information, in deriving financial ratios, financial modelling, stress testing, credit appraisal, credit rating etc. It reflects the position of an enterprise during a given period, which could be quarterly, semi-annual, and annual. Corporations are required to publish financial information regarding the business under different laws across jurisdictions. Why does the balance sheet balance? Balance sheet is balanced because of the double entry bookkeeping system, which necessitates the effect of transaction on two accounts. For instance, an entrepreneur starting a business with $5000 cash will increase cash (Assets) and capital (Shareholder’s Equity). The below equation is the result of double entry bookkeeping system. Assets In the assets section, balance sheet represents the value of a business which can be converted to cash and is owned by the enterprise. Assets represent the ownership of an enterprise. Companies derive assets through transactions, investments, acquisitions, internal developments etc. Assets are generally recorded at a cost which was paid at the time of transaction. But conservative accounting principle necessitates companies to record assets at current costs, and the difference between actual cost and current cost is charged to profit and loss account. The balance sheet does not include internally generated assets like Domino’s Pizza Logo, McDonald’s logo that are valuable for business. However, such intangible assets are recorded in the balance sheet when an enterprise purchases intangible assets or acquire by way of business combinations. Companies are required to report assets less than costs at times like anticipated losses from a receivable are charged to the income statement, and receivable are reduced by same amount in the balance sheet. Depreciation and amortisation is the process charging expenses of long-term assets to the income statement and reducing the same amount from the balance sheet value of long term assets. There are two types of assets: current assets and non-current assets Current Assets: Current assets are those assets that could be realised in cash in one year. These assets include cash, cash equivalents, inventory, trade receivables, financial assets, prepaid assets, financial assets etc. Current assets also indicate the expected amount of cash a business can potentially convert over one year period. It also includes assets held for sale purpose. Current Assets are used to calculate working capital and other financial ratios. Non-current Assets: Non-current assets are those assets that would not be converted into cash easily. These are long term assets of the business and expected to generate long term benefits for the business. Non-current assets include property, plant, machinery, lease assets, intangible assets, financial assets, deferred tax assets, investments, advance, long-term receivables etc. Liabilities Liabilities represent the obligations of an enterprise. It can be the source of assets and also represent a claim on assets of an enterprise. A liability is recorded as a result of past event or transaction, and settlement of liability is expected to result in an outflow of funds, resource or economic benefits. There are three types of current liabilities: current liabilities, non-current liabilities and contingent liabilities. Current liabilities: Current liabilities are short term commitments of an enterprise that are needed to be settled within one year. It reflects the amount of funds that would be required by an enterprise to pay-off its short-term obligations. Current liabilities include trade payables, borrowing, current tax payable, lease liabilities, financial liabilities, provisions, accrued expenses. Information seekers use current liabilities to evaluate the liquidity of an enterprise and various other ratios. Non-current liabilities: Non-current liabilities are also known as long term liabilities of an enterprise because these are due after one year. A company with a loan maturing in ten years’ time will be required to report principal amount under non-current liabilities. Non-current liabilities include long-term borrowings/debt, deferred tax liabilities, lease liabilities, financial liabilities, provisions, capital leases, etc. Contingent liabilities: Contingent liabilities are the obligations of a firm that could become due to the outcome of a future event. Moreover, these are potential obligations of a firm. A common example of contingent liabilities could be litigation against the company, which may force it to pay money upon judgement. Shareholder’s Equity It is the amount of capital the owners or shareholders of an enterprise have provided to the business. Shareholder’s equity also includes the amount of cash generated by the business after repaying all necessary obligations in a given period. Shareholder equity includes equity share capital, preferred share capital, paid-up capital, retained earnings, accumulated losses. Negative shareholder equity would mean that the liabilities of the company exceed assets of the company. A positive shareholder’s equity indicates that the company has surplus assets over liabilities.