Putting It All Together - What the Balance Sheet Can and Can't Do
Analyzing a Balance Sheet
Once again, congratulations on taking the time to come this far in your journey to learn how to analyze a balance sheet. You now have the necessary tools to do precisely that; at least an elementary basis. It can be a huge advantage whether you are reviewing a potential stock investment for your equity portfolio or looking over the accounting records of a family business.
Before you go around exercising your newfound powers of fundamental analysis, you should be careful to understand the limitations of the balance sheet.
It is not the be-all-end-all but merely one piece of a much bigger puzzle. If I were going to sell you the local grocery store or corner gas station, you would almost never want to make an offer based solely on the balance sheet (an exception, perhaps, being if there was some sort of hidden asset that was so valuable you could shut the business itself down, and the liquidation value far exceeds your purchase price). Instead, you would take into consideration the profit the business generated, the future prospects for the business, the local competition, and a host of other factors. The same is true whenever you look at a publicly traded company - you must make a decision as if you were purchasing a private business. This would involve the use of the income statement, which is the focus of Lesson 4, the cash flow statement, and even certain sector and industry resources that can help you better understand the economic forces at work; economic forces that determine sales, costs, and earnings.
Things To Look for When Analyzing a Balance Sheet
What you're looking for when you analyze a balance sheet are the answers to a handful of questions; questions that can help you understand the type of business you're getting, some of the risks inherent in that business, and, in some regards, the talent and ability of management:
- What can the balance sheet tell me about the capital structure of the firm? What are the risks and advantages of using this capital structure? How does this differ from other companies in the same industry or sector? For example, given the steady revenues guaranteed by rate setting boards, public utilities frequently employ large amounts of debt alongside equity whereas many software companies enjoy such obscene levels of profitability, debt is most unnecessary during the expansion phase. If a young software company is saddled with liabilities, that could be a red flag. If an electric utility has a lot of debt coming up for refinancing and interest rates are much higher than they are on the old debt, costs are going to rise, profits are going to fall, and the existing p/e ratio is going to end up being more expensive than it appears. To learn more about the role capital plays in a firm's success, read The 3 Types of Capital.
- What can the balance sheet tell me about the liquidity picture? If the banks closed tomorrow and the capital markets went into seizures, could the firm continue to pay its bills? Back before the credit crisis in 2008-2009, a lot of perfectly fine businesses had become overly reliant upon short-term financing such as commercial paper. That's bad because, despite behaving similarly in good times, commercial paper is not the same as cash and short-term treasury bills. In a recession, you want to be cash rich.
- What can the balance sheet tell me about the quality of the enterprise? Good businesses - the kind that can make your children and grandchildren rich - tend to have a few things in common. Prime among these is an ability to generate high, sustainable owner earnings relative to the tangible book value (stripping out the intangible assets on the balance sheet we've discussed in this lesson) and a shareholder-friendly management that prioritizes existing long-term owners overgrowth for the sake of growth.
- What can the balance sheet tell me about the history of the firm? When you look at shareholder equity section of the balance sheet, you'll see a snapshot of the company or partnership's history. If the business is currently profitable, but you notice enormous book value deficits, that warrants further examination. If it's the result of substantial share buybacks, it may actually be a good thing, provided they put no strain on liquidity. On the other hand, if retained earnings show a negative value, it means there were huge losses at some point in the past. Could they return? It might also mean there is a tax-loss carry forward being used that artificially (but in a very real and beneficial way) increases profitability by reducing the amount the government takes. Once that tax-loss asset is depleted or expired, ordinary tax rates will apply, again, and could cause net income to drop.
Don't Become Overly Reliant Upon the Balance Sheet In Isolation
It's important not to become overly reliant upon the balance sheet alone, seeking some theoretically perfect metric above actual operating execution. You see this from time to time in retail companies. The management gets taken over by people who are derided as "bean counters" with little to no operating experience; who don't understand, intrinsically, the customer experience and psychology of buyers. Instead, they become obsessed with improving the financial ratios from the balance sheet and income statement; things like inventory turnover. They then keep pressing for systems like "just in time inventory" only they press too far. Customers find themselves returning to the store over and over because the shelves are never stocked, or variety has been substantially reduced. In recent years, Wal-Mart Stores, the world's largest retailer, has suffered from this. In my own local market near Kansas City, it got so bad that you could never be sure the spice section would actually have certain spices! Far from improving the business, it simply meant that I, and other customers, stopped patronizing the store in the first place, going to better-stocked competitors.
The same obsessive focus on the balance sheet and other financial statements sometimes happen in other industries, too. Consider banking. Certain banks operate on a low-cost model. They keep minimal staffing levels and have buildings that are acceptable. Other banks use what is known as a "high-touch" approach, with overly-staffed branches and attractive buildings. For a bank that has built its business on the high-touch approach, it could be disastrous long-term to try and increase cash flow and profits by reducing outlays for building maintenance, groundskeeping, and staffing levels because their clients and customers have chosen them in no small part because they like not working their way through a maze of automated machines on the telephone; walking in and interacting with a real person instantaneously; seeing the big, beautiful glass and marble edifice that denotes strength. There are millions of wealthy Americans that happily would - and do - pay a higher price to a bank with a firm that has hidden branches, mahogany paneled walls, and private bankers you can reach nearly all hours of the day. Reductions in balance sheet assets to increase efficiency could very well counter-intuitively lead to declines in revenue that make the assets less efficient in the end.