Weak/Strong Balance Sheet
I hear a lot of talk about how a company has a weak or strong balance sheet, but I'm wondering how you come up with these conclusions. What exactly should one be looking at on a BS to conclude that it is currently weak or strong? What ratios are the best to use? Are you looking at a certain cash percentage? What are the most important line items to assess overall strength?
weak or strong balance sheet correlates to poor or good financial health.
the most common (and simple) ratio that measures financial health is the Debt to Equity Ratio. the way to calculate it is pretty self-expanatory... total liabilities/shareholders equity. the lower this ratio the better.
the current ratio is equally well known. it determines how easily a company can pay off its short term debt. it is calculated by current assets/current liabilities. current assets are assets that can be liquidated within a year, current liabilities are debt that has to be paid within a year. a current ratio of 1 or greater is good, and the higher the better.
the quick ratio is just like the current ratio except its current assets - inventories / current liabilities. this is usually a better representation of financial health than current ratio because inventories are current assets that can sometimes take longer than a year to sell (i think... correct me if im wrong on this)
there are many other ratios you can crunch on the balance sheet. another one is the financial leverage ratio, but i dont remember how to calculate it off the top of my head.
basically a strong balance sheet has more assets (especially cash), and less liabilities. Microsoft is known to have a "Fortress-like balance sheet" (a quote from a Morningstar equity analyst) because it has had 0 long-term or short-term debt over the last 10 years along with over $30bn in cash. and JPMorgan easily has the best balance sheet on the street. just wanted to throw that out there.
hope that helps
The Wall Street Prep Accounting refresher is a good resource to get a handle on the various fin. statements and the various fin. statement analysis/ratios...also check out investopedia.com and other finance related websites
Debt to equity ratio is sort of irrelavant when looking at a balance sheet depending on the company/industry (i.e. balance sheet of a emerging PE Shop) Also, things like current liabilities can be very different from lt liabilities. Ultimately, if I had to pick one line item it would have to be cash. A lack of cash is the main reason business fail.
I don't agree with this statement at all. The cash line on the balance sheet means nothing. Alot of our companies regularly manage the cash balance of the company down through the use of reserves and managing your payables. There are much better uses of cash than leaving it stagnant, in fact any public company will tell you that too much cash on the balance sheet is a bad thing, it either makes you a target or agitates investors who will demand a dividend (i.e. Microsoft). Now the ability to GENERATE cash through operations is different, that's not a balance sheet line item, that's a statement of cash flows item. Being able to generate the cash to service your debt and your working capital and cap-ex requirements are what keeps companies alive and thriving. Having no cash on the balance sheet does not necessarily equate to having no liquidity. For example, if you have a revolver who's borrowing base is derived from your balance sheet line items, you have no need to stockpile cash. Just manage your balance sheet and you'll have a borrowing base that allows you to tap a revolver whenever you're in need of liquidity. So no, cash on the balance sheet does not matter at all.
One example of a company that fails due to liquidity issues, not balance sheet cash issues, is if you let your working capital get away from you. Let's say your company starts getting behind on production and in an effort to save time quality control goes downhill. So not only are you in trouble with your A/R because you're not delivering on time, but your vendors are demanding payment. At some point your vendors are going to halt shipments of materials unless you bring the payables up to a certain level - probably current. At the same time your orders are being cancelled due to late shipments or faulty shipped goods, and you're incurring alot of bad debt. Then it just becomes a never ending downward spiral of your A/R not being collected, your payables being stretched, and your borrowing base on your revolver getting smaller, resulting in a major liquidity crunch.
GameTheory is spot on.
You can't tell the health of a company from the balance sheet alone. The liabilities of the company must be viewed in context. For instance, earnings (cashflow) (eg. EBITDA leverage multiple) or market value of equity (eg. debt/market equity ratio).
And by the way, current and quick ratios don't necessarily tell you anything anyway - negative working capital can actually be a good thing. Think about that one...
more like black hole accounting.
you can't tell shit from this stuff.
when you hear about 'weak balance sheets' it means the company is highly levered. (eg assets/equity > 40. so...200 assets...5 equity...if those assets drop 2.5% in value...uh oh! )
Good thread, lets keep it alive.
When you look at one of the financials that have been under pressure lately and the headlines are talking about balance sheet problems and liquidity problems my question is where are they getting this information from. Obviously they are not getting it from a 10k or 10q because this is stale. I assume a lot of this is rumor driven in equity markets.
"Oh - the ladies ever tell you that you look like a fucking optical illusion?"
wrt to financials, to some extent it's rumor driven sure. companies also drop hints if they're going to need to raise more capital so it's not a huge surprise when it hits.
another thing to remember with financials is that the "strength" of their balance sheet is a lot more important than it is for most normal companies (since finance is pretty much a confidence game). also, there are regulatory issues--non-investment banks that have its capital ratios go out of whack have to raise more capital by law (and thus dilute shareholder equity).
There have been some good answers on this topic. The one thing I would add is to take a look at Accounts Receivable turnover. A company can be very profitable, but if its receivables remain outstanding for a long time, it may not generate adequate cash flow.
can be illuminating, but the reason people talk about the balance sheet being weak or strong is because the BS tells people what you own and what you owe. The income statement and cash flows are facts. But the balance sheet is not - because again we're talking about a) things that are being valued without the benefit of a marketplace, b) debts that may or may not ever be repaid, and c) equity that may one day lose all of its value. Both the concepts of owing and owning have implicit risks. What if what you own suddenly breaks, becomes useless, isn't worth what you thought? What if you can't pay your debts? The idea of a strong or weak balance sheet is an assessment of these very risks. Unfortunately, there is no magic formula to quantify this exactly. If, however, you happen to find it, make sure you make your favorite hedge fund pay you at least $20 million per year in perpetuity just for the privilege of looking at it for 5 minutes.
this thread has been extremely helpful.
What makes a "good" balance sheet? (Originally Posted: 08/19/2014)
As a result of my post on bull markets I've had a few emails and comments asking my thoughts on what makes a good balance sheet. I want to take a few moments in this post to walk through the elements of a good balance sheet, and discuss how it differs from a bad one. I realize this post will probably seem too elementary for some readers, but I think it does provide a good thought lesson. Words like "good", "stable", "bad", and thrown around when discussing balance sheets, but there is no firm definition associated with them. What is a good balance sheet to one investor or company might be a poor for another.
The best starting point for this discussion is to take a step back and consider what the balance sheet even is. A balance sheet is a point in time snapshot of a company's accounts. If a company finalized their financial statements on August 1st that would be the day the balance sheet captures. It's very likely that if the company were to make a second balance sheet on August 2nd that it would be slightly different. Accounts payable might differ due to vendor bills received, or cash due to slight amounts of overnight interest.
Over time a balance sheet should be relatively stable. The last thing an investor wants to see are wildly differing amounts for each reporting period. To see an example of this take a look at a random pink sheet company that spams OTCMarkets with news about significant finds, or notices that the 'books are closed'. These companies will go from having $37 in their bank account to having $200k then back to $109.
A good balance sheet is one comprised of assets that have realizable value and few liabilities, where assets outweigh liabilities. In the course of business all businesses will incur liabilities ranging from accounts payable to potentially the obligation to repay borrowed money. Liabilities aren't something to be feared, they are a byproduct business itself. Investors should try to avoid liabilities that have the potential to wipe out a shareholder's investment, or put the company at risk.
The first liability that comes to mind for most investors is debt, both short term financing and long term debt. But I would argue that any liability that has the potential to disrupt a company's operations is one to be avoided. In some cases the worst liabilities aren't on the balance sheets. An example of this might be a joint venture that has high ongoing capital needs that the owners fund out of cash flow. Another liability to watch out for are contingent liabilities. These liabilities appear in footnotes (not on the balance sheet!) and can have no impact on the business for years until one day they're triggered. The worst potential liability to watch out for are lawsuits. These are similar to contingent liabilities, a company will usually incur no cost outside of legal fees and then suddenly they owe millions or billions for a settlement or ruling.
There's an implicit assumption in accounting that assets are good and liabilities are bad. This is because liabilities are subtracted from assets, and when we subtract we take something away. Usually we want to take away bad things, but this isn't always the case. Sometimes we subtract junk food from our diet, that's a good subtraction. Or we subtract debt from our personal balance sheet, another good subtraction. In the world of finance some liabilities are good such as deferred revenue, or a permanent deferred tax liability. Just like there are good liabilities there are also bad assets.
Not all assets are created equal, and not everything should be taken at face value. Most investors when evaluating a balance sheet make similar discounts to assets, they reduce receivables and inventory by some amount and fixed assets by an even greater amount.
I try to value assets by their potential salability. Marty Whitman discusses this in a video where he comments on Graham's NCAV calculations. Whitman claims that sometimes a fixed asset such as an occupied apartment building has more value than inventory or receivables because it can be sold quickly to almost any buyer.
I would extend Whitman's thinking with some slight modifications. Anything that a company owns that can be sold quickly in any market condition should be valued at face value. In Whitman's example a fully occupied apartment building is worth more than inventory. The caveat I'd say to that is the apartment building could only be sold in an average or above average market. In a credit crunch where a buyer needs to line up financing it might be hard to unload the apartment building. Depending on the nature of inventory it might be easy to unload it. A manufacturing company could have a hard time selling drill presses, but a textile company should have no problem selling commodity fabric.
During the credit crisis many companies realized that what they thought was cash in the form of auction rate securities turned out to be something far different. A month before the crisis any investor looking at a balance sheet would have counted the auction rate securities as cash, but a month into the crisis they would have been discounted 30-50-90% to reflect that these securities couldn't be sold at any price.
The most valuable assets are ones that hold their value. An apartment building, or auction rate securities can be valuable depending on the market they're being sold into. The same could be said for receivables or inventory. Cash in the form of Treasuries or CDs can always be considered worth 100%. An investment in a business that generates cash in all market conditions is also valuable.
If there's a rule about valuing balance sheets it's that there are no rules. What might be good for one company is bad for another. I try to shy away from mechanical formulas, they can be misapplied. It's better to think logically about each company. Is it good for a holiday goods company to have a lot of cash on hand? Yes, to survive the seasonality of their business. For a holiday goods company debt financing might not be bad, they operate from debt for most of the year and then pay back the financing from their seasonal sales.
Excess cash is usually viewed as a good asset, yet in the hands of an acquisitive management team it could be a bad asset. The management team could squander cash on a business that generates losses or incurs significant liabilities. While thinking about excess cash an example came to mind. I was talking to a friend of mine who's a lawyer, we were discussing companies with asbestos liabilities. He told me a story of a local company that purchased another company in the 70s or 80s. The acquiring company closed the deal, and as the deal closed they learned the acquired company had significant asbestos exposure. The acquirer immediately disposed of the newly acquired company, but the asbestos claims hung around. They owned the company laden with asbestos claims for less than 100 hours, and 30-40 years later they're still paying out on legal liabilities.
Like all of investing I don't believe simple mechanical rules are good enough. I think one needs to look at each company and think over potential situations and scenarios. Rules miss a lot, cash is good, debt is bad, except in cases x, y or z. Instead a better way to approach a balance sheet is to keep in mind that assets that are readily salable and hold value in any market are valuable, and anything that bleeds cash, or anything that puts the company in a bad financial position is bad.
The appropriate amount of leverage
Great post, thanks for simplifying this. Not all balance sheets are created equal, with the small exception of the sample balance sheets used in my financial accounting class. The skill consider all possible and materially-relevant scenarios for every item on the balance sheet seems really impressive from my perspective as an intern who worked in Capital Markets, not IB. Would be pretty cool to get to this level for an interesting industry if I make the transition to banking. Although, this could all be relatively basic and I'm just behind the banking curve.
hella cash
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