The balance sheet continued, let’s get to it. You might have some questions. How do I interpret these figures? What should I look for? If you missed my earlier post on how to read the balance sheet, click here.
Debt – It’s Hard to Go Bankrupt Without It
Generally, I stay away from companies that have year-over-year rising long-term debt. For me, it tells greatly about how management views debt. Since debt is not management’s personal obligation, but instead “other peoples money” it raises my concerns if management’s interests align with the shareholder (you as an investor). When looking at the balance sheet and you see rising debt levels, what has it been used for? If its for acquisitions, this may be a huge red flag. Acquisitions are notorious for their failure rates and over-payment by the acquirer.
Working Capital – Positive Preferred
Next, you want to find the “Current Ratio” also known as “Working Capital Ratio”. The term “Working Capital” refers to the company’s ability to get through a full fiscal year. It is calculated as: Current Assets – Current Liabilities. Year over year, I like to see a company with a stable current ratio of 1.5 or more. 2.0 is great. If a company’s current ratio is 1.5, this means that they own 1.5€ for every 1.0€ of debt owed. Now, if a current ratio gets too high (e.g. 3.0 and above) you might want to stay away. This may be a sign that management is under-utilizing its assets and not performing as efficiently as it could be.
Not All Debts Are Created Equal
Although I prefer low debt levels, I have made investments in companies that use leverage. If you do invest in leveraged companies, you want to be as certain as possible that the debt is modest and manageable. If management explains their motivations for leverage in shareholder letters, this is a good sign. Look at the past. Has past debt taking resulted in the results that its intention was? Has the company been able to pay away previous debts in a reasonable time span? What I do is I look at the companies operating earnings (annual), and compare it to the debt. If a company could pay its all debt away within 4 years, this is encouraging.
Assessing Intangibles Can Prove Difficult
You may come across the item “Goodwill” on the balance sheet. Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill. Be wary of rising goodwill numbers. This usually means the company is on an acquisition binge and odds are it will run into trouble. Rising inventory levels may also spell trouble (unless sales are rapidly expanding). If inventory grows, but sales are stagnant, this could mean the company is struggling to sell its product.
Growing Equity – Growing Wealth
The shareholders’ equity should preferably be growing over time. As a shareholder, you are a business owner and you want your “net worth” stake in the company to gradually increase. One common method to measure your invested capital’s efficiency is Return On Equity, or ROE for short. It is calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE could be thought of as the return on net assets. This is a number to pay attention to, and is in fact one number Warren Buffett emphasizes. Generally, look for a consistent 15% or higher ROE without drastic fluctuations.
To summarize, an ideal balance sheet would include at least the following: Rich in cash, low in debt, growing shareholders’ equity and consistently good ROE. There may be further items that I left out, but I’m sure the balance sheet is a topic I will return to in the future.
Next up, the final part of the three part series: The Cash Flow Statement.
-IGTSKasimir
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