"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"
How I Read A Balance Sheet
In order to make good, sound investments in the stock market, there are a number of things that you need to consider. Some of these items include what underlying company does, its dominance in its particular fields of expertise, earnings consistency, dividend payouts and sustainability, and valuation.
Another important thing to look at is the financial condition of the company in question. You need to know whether or not the company can pay its bills, and how much debt it carries, because these items influence the net worth of the company and the value of the company's stock. This is where the balance sheet comes in. The balance sheet gives you an accurate breakdown of the company's assets against all of the company liabilities, or debts. The difference between the assets and the liabilities is the shareholders' equity of the company, also known as net worth, or book value. When used properly, the balance sheet can help you effectively determine the financial condition of a company and whether or not that company's stock is a good investment.
In this article, I will provide an illustration of what a balance sheet is, and go through the most important items that you should be looking at while you do your due diligence toward making sound investment decisions in the stock market.
Balance Sheet Of XYZ Company ($ in millions)
|Cash and Cash Equivalents||$6,643|
|Total Current Assets||$22,028|
|Property, Plant, and Equipment||$21,204|
|Short / Current Long-Term Debt||$9,819|
|Other Current Liabilities||$0|
|Total Current Liabilities||$26,230|
|Deferred Income Taxes||$1,567|
|Total Shareholders' Equity||$67,486|
|Total Liabilities & Shareholders' Equity||$131,066|
Cash and Cash Equivalents
The first line on the balance sheet shows how much cash the company has on its balance sheet. The more cash that a company has on its balance sheet, the better, as more cash gives the company the ability to invest for more growth, make acquisitions, buy back stock, or even pay dividends to its shareholders. Some of the larger and more mature companies don't carry a lot of cash on their balance sheets, as they are usually more inclined to either buy back stock with it or pay out dividends, as opposed to letting cash pile up on the balance sheet over time. You can monitor a company's share buyback and dividend activity by looking at its cash flow statements. You should also pay attention to where the cash is coming from, from one quarter and one year to the next. It usually comes from one of three sources: earnings, the sale of its assets, and either borrowing money or issuing shares. Ongoing operations and sales of non-core assets are generally thought of as good sources of cash. When a company has to get cash by borrowing money or issuing shares, that might not a good sign, depending on the situation. It's always best to consult the company's SEC filings to get up to speed on these happenings. The amount of cash that a company has on its balance sheet is also used by some investors when it comes to properly valuing a stock. For instance, a stock that trades at less than 10 times its cash position is often thought of as a potential bargain.
Net receivables are monies that are owed to a company for goods or services that it has already provided. The problem with having a lot of receivables on the balance sheet is that there is always a chance that some customers won't pay. For that reason, you usually like to see net receivables make up a small percentage of net sales over a given period of time. What constitutes a small percentage of sales varies from one industry to the next. The best thing to do when analyzing this part of the balance sheet is to compare the numbers with the company's closest competitors. Information on sales can be found by consulting the company's income statement.
When you're dealing with the stocks of manufacturing companies, you will find that inventory is a major contributor to the balance sheet. Inventory consists of raw materials, finished goods, and goods that have yet to be finished, also known as work-in-process. Most companies will provide a breakdown of their inventories on their SEC filings to show investors how much of their inventory is finished goods. If a company has a lot of finished goods in inventory, it may indicate that they are having difficulty selling them. I usually like to see inventory levels that are stable or slightly rising from one year to the next. If inventory levels are rising, then I also want to see revenues rising as well, to show that there is more demand for what the company is producing. I don't like to see inventory levels that rapidly fluctuate. This type of behavior is typical of boom and bust cycles. If you're seeing inventory levels ramp up without accompanying increases in sales, then it may indicate that some of the company's products are going obsolete. This is why I like to keep to stocks that produce things that people are always going to need, like toilet paper, food, and telecom services.
The three items that I just discussed are known as current assets. This is because they are either cash or items that can be converted to cash within the next 12 months. It is important for a company to have a certain amount of these assets on hand in case their operations are disrupted by unforeseen circumstances, like natural disasters or a labor strike. If you look at the balance sheet above, you will find an item called "current liabilities." Current liabilities are liabilities, or debts, that come due within the next 12 months. These liabilities include accounts payable (expenses that occur in the regular course of business), and short and long-term debt that come due in the coming year. If the company's operations are shut down for a prolonged period of time, then it will need to use its current assets to pay for its current liabilities. To insure that a company has enough of these assets on hand, we calculate what is known as the current ratio. The current ratio is what you get when you divide the number of current assets by the number of current liabilities. When the current ratio is at or above 1.0, the company has enough current assets on hand to meet its current debt obligations. A lot of investors like to see this number at 1.5 or higher. However, if you're dealing with a large, multinational company that has operations all over the globe, then you may find that the current ratio is well below 1.0, but don't let this dissuade you, as it is highly unlikely that their operations will come to a grinding halt. For smaller companies, whose operations are concentrated in just one or two places, the current ratio is a much bigger concern.
If the company that you are researching has a lot of inventory on hand, then the quick ratio may help you in your research. While inventory is considered to be a current asset, in that it is usually converted into cash within a year, there may be some instances when it can't be converted into cash. For instance, an inventory of obsolete products is worthless. The quick ratio will tell you whether a company can meet its short-term financial obligations without having to depend on its inventory. To calculate it, just subtract the inventory from the current assets and divide the rest by the current liabilities. You generally want to see this figure at or above 1.0. However, as is the case with the current ratio, larger, more established companies will often have a quick ratio of well below that threshold.
Property, Plant, and Equipment
Now, we are into the non-current assets, which are assets that the company does not plan to convert into cash within the next 12 months. Virtually every company has a certain amount of plant, property, and equipment on its balance sheet. Land has to be purchased, factories and offices have to be built, and machinery must be purchased in order for the company to operate. However, less is more in this regard. A company that has to constantly upgrade and change its facilities in order to keep up with its competition may be at a disadvantage when compared to companies that operate in other industries. Companies with durable competitive advantages don't have to constantly upgrade their facilities in order to stay competitive. I usually like to see property, plant, and equipment levels that are either falling or stable. If they are rising from one year to the next, then I will consult the company's most recent annual or quarterly filings to find out what is going on.
If a company purchases another company for more than the acquired company's net worth, then that excess purchase amount is known as goodwill. Companies that make a lot of acquisitions will have a lot of goodwill on their balance sheets. However, a lot of goodwill can be a problem, especially if the acquisitions don't produce the value that the company originally expected. If an acquisition doesn't produce, then the company will normally take a write-down on the value of the acquisition, erasing some of the goodwill off of the balance sheet, making the company worth less money, which will often translate into a lower stock price. For this reason, I usually don't like to see goodwill account for more than 20% of a company's assets. However, a company with a lot of goodwill on its balance sheet isn't necessarily a company whose stock should be avoided. This is because smaller companies that have sustainable competitive advantages are very seldom bought at book value or less. This is why each acquisition needs to be examined on a case-by-case basis before a well-informed judgment can be made.
Intangible assets are assets that cannot be touched. These assets include copyrights, trademarks, brand names, and patents. They are marked on the balance sheet at their fair market values. Any fluctuations in their fair market values are reflected on the company's next balance sheet. Intangible assets that only good for a certain period of time, like patents, will have their values amortized over their useful lives, with charges being applied to the income statement and balance sheet every year to reflect that. All intangible assets that are on a company's balance sheet are assets that were purchased from someone else. Internally-developed intangible assets don't go on a balance sheet like they used to. This rule keeps companies from slapping on any old fantasy valuations onto their balance sheets.
Return On Assets
The return on assets gives you an idea as to how efficient management is with the company's assets. It tells you how much earnings the company is able to generate with every dollar's worth of assets. Generally speaking, the higher this value, the better, although smaller values may be acceptable with companies that have large asset totals. This is because large asset totals can present a large barrier to entry for potential competitors. The more money that a potential competitor has to have in order to "get into the game," the less likely it is that that company will actually be a competitor.
The return on assets is calculated by dividing the net income by the company's total assets, and then multiplying the resulting quotient by 100 to get a percentage. You usually like to see double-digit returns on assets, but high-single-digit returns on assets are usually acceptable for larger companies.
Short-Term Debt Versus Long-Term Debt
Short-term debt is debt that comes due within a year, while long-term debt is debt that matures after that. You generally don't like to see companies with short-term debt that exceeds long-term debt. If a company has an exorbitant amount of short-term debt, then there may be questions as to whether the company is prepared to handle it.
Long-term debt is debt that is due more than a year from now, but too much of it can be crippling. For this reason, the less long-term debt a company has, the better off it usually is. Companies that have strong competitive advantages in their areas of business usually don't need a lot of debt in order to finance their operations. Normally, they can do this with their earnings and cash flows. As a rule of thumb, a company's long-term debt should not exceed more than 3 or 4 years worth of its earnings. When I determine the strength of a company's earnings relative to its long-term debt, I calculate the average of its core earnings over the last three years, and divide that into the amount of long-term debt. That will normally give me a fairly accurate picture as to how much of a problem its long-term debt is.
Deferred Income Taxes
Deferred income taxes are simply taxes that are due but have yet to be paid. This doesn't really tell us anything about whether the company has any sort of competitive advantage in its area of business.
The Other Liabilities category is more of a "catch-all" category that includes items such as court judgments issued against the company, non-current benefits, and unpaid fines. If the company that you are researching has a large chunk of these "other liabilities," then you should consult its latest SEC filings to find out what's going on.
The first line in the equity section of the balance sheet is for preferred stock, if the company has any issued. Ideally, you don't want to see any preferred stock on the balance sheet. Those who hold preferred stock don't have voting rights in connection with their shares, but they are guaranteed a dividend that must be paid before any dividends are paid on common stock. In the event of a bankruptcy, preferred shareholders take priority over those who hold common stock. Companies who need to borrow a lot of money will often have preferred stock on their balance sheets. They sell it on the open market in order to raise money. However, unlike the interest on a loan which can be deducted from taxable income, dividends paid to holders of preferred stock are not deductible, making the issuance of preferred stock an expensive way of obtaining capital. Companies that have strong competitive advantages and can finance their operations through earnings and cash flows, won't have this on their balance sheets.
Holders of common stock do have voting rights in connection with their ownership, and can elect a board of directors. They are entitled to dividends when the board of directors deems it appropriate. If the company gets sold, the common stockholder gets paid.
Capital surplus is also known as additional paid-in capital. When a company sells its stock on the open market, the par value is recorded on the lines of preferred and common stock. Any money that was paid for the stock in excess of par value is listed on the balance sheet as capital surplus. If the par value of the stock is $100 per share, then $100 per share is recorded under either preferred stock or common stock. If that stock was sold for $150 per share, then $50 per share will be recorded under capital surplus.
Retained earnings are the amount of earnings that the company chooses to reinvest into its business. It is calculated by subtracting the amount of earnings that is used to buy back stock and pay out dividends from the total earnings. It is an accumulated number in that it adds up all of the retained earnings from every year. You want to see this figure grow year after year, because an increase in retained earnings means an increase in net worth. You really want to see some growth here if the company in question doesn't pay out dividends or buy back stock. If a company doesn't do either of those two things and has no retained earnings, then that means that the company isn't making any money. It should be said that larger and more mature companies don't have very high growth rates in retained earnings, as they are more inclined to pay out the majority of their earnings to shareholders.
Treasury stock is listed in the equity section as well, and represents shares of stock that the company repurchased, but has yet to retire. The company can re-issue these shares at a later date if they need to. While treasury stock is a negative on the balance sheet, you generally like to see a lot of it on a balance sheet, as fundamentally-strong companies will often use their strong cash flows to repurchase stock, in order to increase the value of the remaining shares outstanding. When I calculate the company's debt-to-equity ratio, I like to exclude the treasury stock from the equity for this very reason. Most companies that buy back stock don't need a lot of equity in order to operate, and a lot of treasury stock can give the company a debt-to-equity ratio that makes them appear to be severely distressed, when in reality, it is far from that. I also like to exclude treasury stock from the calculation of a company's return on equity.
The debt-to-equity ratio gives you more insight into the financial health of the company. It tells you how much money the company owes, relative to its net worth. The lower this ratio, the better. It is calculated by dividing the total liabilities by the shareholders' equity. Generally, you don't want to see companies with a debt-to-equity ratio above one. In the case of XYZ Company, whose balance sheet is above, here is how the ratio is calculated.
Debt-To-Equity Ratio = Total Liabilities / Shareholders' Equity = $63,580 / $67,486 = 0.94
Now, if you calculate this ratio like I do, and strip out the negative effects of treasury stock, then you have this:
Debt-To-Equity Ratio = Total Liabilities / (Shareholders' Equity - Treasury Stock) = $63,580 / $139,168 = 0.46
It looks like XYZ is in pretty good financial shape relative to its debt-to-equity ratio.
Return On Equity
As is the case with return on assets, the return on equity is a measure of how efficient the company's management is. It is a measure of how much earnings management can generate from every dollar of company net worth. It is calculated by dividing the company's net income by its shareholders' equity. However, you have to be careful with the return on equity, as a company with a lot of debt will have a very small equity position, causing returns on equity to be very high. If you're seeing returns of equity of 40% or more, then you may want to dig deeper and find out how much debt the company has. Very high returns on equity can also be caused by smaller equity positions that result from a lot of treasury stock. To take this into account, just exclude the treasury stock from the equity calculation, and that will give you a number that more closely reflects how well the company is doing.
So, now you know more about the many different items that go into a balance sheet and how you can use them to figure out whether the company in question has a sustainable competitive advantage and whether or not the company's stock makes for a good investment.
"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"