A brief look at the balance sheet
Page 1 of 3
Karl Siegling is a portfolio manager at Cadence Capital.
We should start this by admitting from the outset that we can never do this topic justice in one article. Entire textbooks have been written on the topic -- and even they miss large sections of important information.
What is worth outlining, though, is some of the "big picture" or "helicopter" items worth looking at on a balance sheet.
It is fair to say that investors spend much more time looking at profit and loss statements than balance sheets, but that looking at balance sheets actually offers better insurance for finding potential problems within a business -- these won't necessarily be evident in a profit and loss statement.
Cash and debt
Probably the most important thing to assess on a company's balance sheet is the level of cash and debt and the changing profile of that cash and debt over time.
Increasing cash levels and reducing debt levels are usually good signs. Escalating debt levels and reducing cash levels over time bear further investigation.
Large cash levels or debt levels for a company relative to its market capitalisation can be tell-tale signs of levels of relative comfort (high cash levels) or relative distress (high debt levels).
Very often, high debt levels lead to bankers forcing the board and management to raise new equity at significant discounts to prevailing market prices, which severely dilutes existing shareholders' ownership. The Australian listed landscape is littered with examples of this over the past five years.
Cash and debt affect the enterprise value (EV) of a business, or in plain English, help you measure more accurately the amount of money employed in earning a particular return.
Debtors and creditors
Large movements in debtors and creditors or very high debtor or creditor numbers, relative to revenue or major costs of the business, need to be examined carefully.
Large and escalating debtors can signal a slowing in payments from customers or even potential doubtful or bad debts and may warrant investigation in the notes to the accounts. Conversely, large or escalating creditors could signal a company's inability to pay invoices when they fall due.
Sometimes, high creditors may simply mean that a company has negotiated good, long payment terms on outstanding invoices and this probably bears further investigation as well.
A large difference between the level of debtors and creditors can also signal working capital problems within the business or, conversely, may signal very tight and disciplined controls around the receipt and payment of accounts, showing a well-run business.
Calculating some basic working capital numbers, in conjunction with reviewing a company's cash-flow statement to make sure working capital is in order, is often a useful tactic.
Uncover winning investment ideas and strengthen your portfolio with a 4-week free trial to Premium:
- Your Money Weekly Newsletter
- Independent Fund Analyst Research
- Portfolio X-Ray
- Investment Picks