Having covered a number of company fundamentals that demonstrate how a company is operating (Turnover, Profitability and Leverage), this article will examine the Balance Sheet, which provides an overview of a company’s assets and liabilities, as well as the shareholders’ equity at a given point in time. Each of these sections includes many sub-accounts which provide more detailed information on short-term and long-term debts and incomes, as well as items such as property holdings and inventory levels.
Broadly speaking, assets and liabilities are broken into two types; current (those due within 12 months) and long-term. Examples of current assets include things like cash, accounts receivable (money owed by customers for goods and services) and inventory, whereas long-term assets are those which are harder to convert into cash such as investments, machinery, properties or copyrights.
Likewise, current liabilities are things like accounts payable, salaries, leases and rents, and long-term liabilities are things like bonds, deferred taxes and payments owed to the pension fund. The sum of the assets listed on the balance sheet must be equal to the sum of the liabilities plus shareholders’ equity (which is essentially the money originally invested in the company, plus any retained earnings).
Reading a Balance Sheet
First, it is important to understand that not all items recorded as ‘assets’ are equal. Although I can take cash from a company bank account and spend it tomorrow, I cannot take ‘goodwill’ or ‘copyrights’ and do the same thing as they have no guaranteed and immediate cash value.
Likewise, if a company is recording £10m of assets on its balance sheet, but £7m of these are in accounts receivable, I question how much of that £10m the company will actually receive. Some customers that owe money will refuse to pay, others will be unable to do so, and so it is likely that the company will receive less than expected of 70% of its declared assets. Quite how much depends upon the market, economic conditions and a degree of luck, but multiple companies have misjudged this figure and later had to declare significant write-downs as a result.
If a company is racking up too much debt by not paying bills or borrowing too much money, this is also cause for concern. Although theoretically, the balance sheet must balance (assets must equal liabilities plus shareholder equity) time and time again solid-looking companies have suddenly declared financial difficulty after their assets were found to be insufficient to repay their liabilities.
This is an important point to remember. Boards and Directors have a fiduciary duty to their shareholders, but as far as I’m aware, no one has ever been prosecuted for being overoptimistic when declaring assets. Auditors are supposed to attest to the quality of assets, but time and time again, we’ve seen examples of companies declaring write-downs on their assets and forecast incomes.
Ultimately, I want to see a positive cash balance, a low level of debt relative to cash and income, a low debt-to-equity ratio and a strong return on equity. These features ensure that a company has sufficient capital to continue operating and investing for the future, and to pay out dividends (providing those dividends are a percentage of available cash and that they aren’t borrowing to fund them).
Investing isn’t an exact science – I can’t click a button and guarantee the same result every time. Some companies declare bumper earnings reports and barely move, and others with tenuous balance sheets seem to climb and climb. Over the long-term, however, investing in well-run companies that have diverse and charismatic products and services will not fail to produce a reasonable return.
Part of market action will look random to the casual observer because it is based on the discreet actions of millions of individual parties all responding to different criteria. Although we have more information than ever about publicly listed companies, that volume also means that we’re all looking at different things at different times.
The day I decide to buy one company might be the same day that my neighbour decides to sell it because he wants to use the money to buy a boat and a third person decides to move out of equities and into Gold because they just heard someone say that Russia was going to start World War Three next week. Neither of those things have anything to do with the company itself, but the fact that two people sell when one is buying will force the price down (if we’re trading equal volumes at the same time).
Likewise, I refuse to invest in some companies that fail to meet my criteria and in doing so have undeniably left profits on the table. If I had bought Micro Focus International shares in 2014 at £7.79, they would have been worth £27 at the end of 2017. I didn’t bother investing in either of these companies however, as neither met my buying criteria.
Instead, I invest in companies that I can understand and whose balance sheets I like the look of. I eschew high debt levels (with the exception of Carillion, which later failed due to the poor quality of its assets and the high levels of debt). Ultimately, this has produced a reasonable return for my portfolio, but has no come without headwinds. Over a lifetime, any portfolio is going to face fluctuations and challenges, but that isn’t a reason to avoid investing altogether. That logic would mean that because there is a risk of getting stabbed or being run over, it’s better to never leave your house without a stab-proof vest and to never walk alongside a road.
There are certainly people that treat the stock market like a casino. They rush from idea to idea, only concentrating on the list price of companies without really considering what they’re investing in. It’s that same mentality that has seen Amazon reach a ridiculous price to earnings ratio of 150 (meaning that for every dollar it earns investors are willing to pay $150 dollars).
Yes, you read that correctly. A dollar from Amazon is worth exactly the same as a dollar from anywhere else, so why some investors are willing to pay that much for it, I have absolutely no idea. Well, I do. Because they look at the name ‘Amazon’ and are willing to buy it at any price. That’s not investing, that’s speculating. It’s hoping that someone will turn up in the future that is willing to pay more money than you paid. It’s completely ignoring the fundamentals of the business. And it will end in tears for millions and millions of people that have put their money into the company.
Ultimately though, that approach is as far removed from investing as a child with a crayon is from Leonardo da Vinci and hopefully, this series has helped to explain why.