Probing Foundations: Balance Sheet Basics

Foreword from ShareInvestor

This article “Probing Foundations: Balance Sheet Basics” by Cai HaoXiang was first published in The Business Times on 04 Apr 2016 and is reproduced in this blog in its entirety.

Investors will be well served to do a detailed study of a company’s balance sheet

Beginner investors often think they can divine everything about a company by just looking at its income statement, calculating one or two ratios, and committing to buy when everyone else is buying.

Months or years down the road, the stock of the company suddenly begins a precipitous dive.

You hear whispers about “unpaid receivables”, “inventory markdowns” … or was there something about a looming bond principal payment?

Oh, but you never paid attention to those numbers. You mean they were important?

Oops. You watch aghast as the company’s share price tanks, independent directors quit, the stock gets suspended, and your investment goes to zero. Hey! Wasn’t the same company reporting a 30 per cent growth in profits just two years ago?

It’s not too late to learn one of the most important things in stock-picking: Reading the balance sheet to understand whether a company is operating on a solid foundation.

A careful analysis of this financial statement will not only minimise the chances of investing in a company on its road to bankruptcy.

Confidence in a company’s balance sheet will also make you dare to invest during a business downturn, at a time when most people are afraid.

The Personal Analogy

So what is a balance sheet?

An analogy is found in personal finance. Your personal income statement details your revenue (wages, plus bonuses) minus your expenses (spending on bills, food, transport), such that you can tell whether you are living within your means with a positive “net profit”, or not.

While the net profit number is a figure computed usually over the course of a year, your balance sheet shows what you are worth at any one point in time.

To draw up your balance sheet, you need to sum up your tangible assets first: Cash balances in the bank, in your wallet, and in spare notes lying around the house, and the value of every single thing you own, notably your house and car but possibly, depending on your tastes, your sofa, your sound system, your silver cutlery, your dog and pet terrapin.

Then you sum up your liabilities, which refer to the amount of debt taken to fund those assets. Debt does not belong to you, so you have to subtract that from the value of what you own.

The remainder is your net worth, otherwise known as equity. Hopefully, you are above water here.

The balance sheet equation is thus simply: Assets – Liabilities = Equity, or Assets = Liabilities + Equity.

Balance Sheet Components

And so it goes for corporates. Companies are started by stockholders, who put up cash for a business to get going.

The cash then gets used to buy long-term assets like land and factories, from which they produce goods for sale, or inventories, recorded as short-term assets.

Sometimes factories require large amounts of money to build, far beyond what the original shareholders of the company can contribute. Thus liabilities like debt might be incurred to fund the purchase of assets.

On the balance sheet, accountants divide assets and liabilities into short-term (current) and long-term (non-current).

Current assets are expected to be convertible to cash within a year. These include items known as receivables, which are what customers owe the company. For example, a car manufacturer might sell directly to its customers, who then take, say, three years to pay back the sale price of the car. Until the customers pay the manufacturer, the amounts due are recognised in receivables.

Current assets also include inventories, which are raw materials, works in progress, and finished goods made by the company. Inventories can be sizeable for manufacturing and trading companies.

Long-term assets, or non-current assets, refer to land or factories as previously mentioned. These are recorded under an item called property, plant and equipment.

These assets, once purchased, do not hold their value forever. For example, we know the value of a car in Singapore goes down over time, partly because the Certificate of Entitlement (COE) tied to the car’s purchase has a lifespan of 10 years, and also because of natural wear and tear.

Similarly, machines purchased have a lifespan. The process of reducing their value based on their lifespan is known as depreciation. Typically, companies practice straight-line depreciation, which spreads depreciation costs evenly throughout the working life of the asset. Depreciation costs are recognised in the income statement.

On the liabilities side, short-term debt payable within a year is recorded under current liabilities, and longer-term debt is recorded under non-current liabilities.

Current liabilities also include payables, which are what a company owes its raw material suppliers. Large-scale factory purchases of raw materials can be made on credit and not cash. The bigger the company, the more bargaining power it has with its suppliers, and the longer it can go without paying them.

Using the same example of the car manufacturer company, the factory might buy steel sheets and paint from other companies. It might only need to pay its suppliers in, say, two months upon being invoiced for the raw materials purchased.

The Current Ratio

Dividing a company’s current assets by its current liabilities gives you the current ratio.

This is a reflection of how quickly a company’s assets can be sold off to meet short-term debts.

Like all ratios, the current ratio does not mean anything on its own. It is more useful as a comparison over time, or with other companies in the same sector.

For example, a rapidly falling current ratio can indicate potential financial distress.

A low ratio below 1 does not mean anything on its own. Some companies, like telcos, operate with current liabilities significantly above current assets. Yet this does not indicate financial distress especially if lenders are confident in the company’s long-term prospects.

A high ratio also might not mean much as some short-term assets like inventories might not be as easily convertible to cash. In an economic downturn, it might take more than a year to get rid of all your inventory, especially if there is a global oversupply of the item that you hope to sell.

Some people thus use what they call the quick ratio, which excludes inventories from the current asset total, before dividing that by current liabilities.

A high current ratio might not mean much without knowing the length of time that it takes for suppliers to be paid and for customers to pay what they owe.

In our simplistic car example, the manufacturer might want to boost sales by offering a zero downpayment on a new model of a car. Perhaps customers can take up to five years to pay them back.

But the manufacturer has to pay its suppliers within two months for the raw materials it used to make those cars.

If the cash needed to pay its suppliers far exceeds the cash that the company needs to receive from its customers, and the company cannot borrow enough from banks to make up the difference, it is in trouble.

Asset Impairments

One principle to live by when evaluating the balance sheet is to constantly wonder whether assets are actually worth as much as they are recorded. Liabilities are more often than not real, unfortunately. Suppliers and banks need to be paid. They will not write off your debts easily.

But assets might not be.

Property is one culprit, because some companies revalue property values up every year based on valuation reports from property consultants. In a downturn, these numbers can take a significant hit.

Back to the car example, you might be a traditional car manufacturer and have made plenty of combustion-engine cars that you expect to be able to sell.

These cars are recorded under the finished goods component of inventories, which reflect their cost price.

Tomorrow, a new electric car competitor might come onto the market with a superior offering at a significantly lower price. All your existing cars might not be able to be sold at the multiple of the cost price that you planned to charge your customers.

The cars might not even be able to be sold at cost. Maybe they are now only worth half of their cost price.

As a result, you will have to do the dreaded “inventory write-down”, essentially adjusting the value of your existing inventories down to what they are actually worth on the market.

A big impairment will be made. This refers to the accounting process of marking down the value of an asset on the balance sheet.

If an economic downturn hits, your customers might not be able to make their car payments on time. A growing portion might not even be able to pay if their house gets repossessed.

Perhaps you can repossess the car if the customer is unable to pay. Then you run into the inventory problem: How are you going to sell all these cars? Either way, a write-down is inevitable.

The best way to see how a slowing economy affects companies is to look at the balance sheets of China companies. Singapore-listed Chinese shipbuilder Cosco Corporation, for example, saw its receivables grow to S$5.2 billion at end-2015 from S$4.6 billion at end-2014. Cosco builds ships for the oil and gas industry.

Whoever ordered all these ships is not paying Cosco back so fast.

A higher receivables count is natural if revenues are also growing. But for Cosco, revenues fell to S$3.5 billion in 2015 compared to S$4.3 billion in 2014. Falling revenues accompanied by increasing receivables are a clear sign of trouble. Not only are you selling less to your customers, they are also taking longer to pay you.

For firms that make goods in an attempt to anticipate customer demand, like retailers, rising inventories at a time of slowing growth also signal trouble.

The Debt Trap

Compounding the issues of potential asset markdowns are issues of debt repayments.

A drastic markdown of inventory values is not the end of the world. You can still sell your goods for cash and redeploy the cash to hopefully better uses.

The inability to pay back your debts, however, leads to bankruptcy. The best way to avoid this circumstance is to stay away from heavily indebted companies.

To assess how indebted a company is, one ratio we can use is the net gearing ratio, otherwise called the net debt to equity ratio.

Net debt is the cash on the balance sheet minus all debt taken on.

If you are left with a positive number, you are “net cash”. There’s nothing debt-related to worry about here – unless the cash is not real, of course.

Meanwhile, many companies will be in a situation of “net debt”. This means that even if they took all their cash to their lenders, they would not be able to pay back all the debts they owe. They will have to depend on future cashflows from investment projects or sales of goods.

Debt refers to short-term and long-term borrowings and bonds issued. The borrowings can be secured against collateral, or unsecured.

Arguably, leases also need to be included in debt calculations. Companies sometimes lease properties from landlords, effectively having to pay a fixed sum regularly for the use of an asset.

It is debatable whether we include debt related to operational issues, such as what is owed to suppliers known as trade payables.

Either way, you thus calculate net debt, and divide the number you get by the equity due to shareholders in a company.

What net debt to equity ratio you are comfortable with is up to you.

I like to use a personal analogy.

Let’s say you start out with S$400,000 in cash. You buy a condo worth S$1 million, using S$200,000 of that cash as a downpayment.

You thus borrow S$800,000. That’s your liabilities. You have S$200,000 left in cash, plus the S$1 million condo. That’s your assets.

Your equity is S$1.2 million in assets minus S$800,000 in liabilities = S$400,000, or what you started out with. Your net debt, meanwhile, is S$800,000 of debt minus S$200,000 of cash, or S$600,000.

Your net debt to equity ratio is 150 per cent, or 1.5 times.

This can be a pretty uncomfortable situation if your property’s value drops 50 per cent to S$500,000 in a market crash the next day.

If you still have S$800,000 owed, you are now severely underwater. You can’t sell your house for S$500,000 to pay back S$800,000. Creditors are knocking on your door. You don’t have enough cash either. Your total assets are S$700,000 while you owe S$800,000.

You can’t sell your home, you certainly can’t borrow more, and you can only hope to have a job to keep paying the mortgage, while you wait for prices to recover.

Conversely, what if you spent the same S$200,000 in cash to make a downpayment for a S$500,000 resale flat? You borrow S$300,000. Your total assets are S$700,000, and your equity, S$400,000 like before.

Your net debt is S$100,000. Your net debt to equity ratio is 25 per cent, or 0.25 time.

A market crash arrives. Your flat falls 50 per cent in value to S$250,000. Your total assets are now S$450,000. You still owe S$300,000, and the value of what you owe is still more than the value of the flat.

But you sleep soundly at night, because you are still in positive equity territory – S$150,000 to be exact. You can pay down your debt with your cash such that you only owe S$100,000 on a S$250,000 flat.

So I am much more comfortable with companies with a net debt to equity ratio of 25 per cent. I wouldn’t touch companies with a net debt to equity ratio of more than 100 per cent, no matter how attractive the growth story is. I am uncomfortable with 70-80 per cent. There are dangers to leverage, and the rewards are usually not commensurate with the risks.

To sum up, the balance sheet is a critical component of financial statements that investors cannot miss, summarising what a company owns and owes. The balance sheet is divided into short-term and long-term assets and liabilities, otherwise known as current and non-current assets and liabilities.

The value of assets is not what it seems. Assets can get impaired. And too much debt remains the main cause of companies going bankrupt. Be careful.