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Balance Sheet Analysis
- Leverage and financial
strength affect share value
- Liquidity concerns can
decimate a business
- Cash is critical, to a point
* Window Dressing
* Cash Gap
* Cash per Share
* Burn Rate
- Marketable Securities
- Receivables are interwoven
with cash flow
* Past Dues and Write-offs
* Receivables turnover ratios
* Securitizations
- Inventory - focus on the
profit
margins
*
Perpetual vs. Periodic
Inventory
* Inventory Accounting
Calculation
* Inventory Costing Methods
* Lower of Cost of Market
* Inventory Categories
* Inventory Turnover Ratios
- Fixed assets are necessary in
order to be a world class
company
- Liabilities with equity attributes
are enriching
- Emphasizing debt net of cash
can be misleading
- Book value is a tool to
properly evaluate a stock
- Off-balance sheet assets and
liabilities are legal
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Liquidity
concerns can decimate a business
Liquidity is a company’s ability to pay its
short-term liabilities as they come due. If a company cannot pay its bills,
suppliers will stop shipping, customers will squeeze it on price, banks will
increase fees, and its employees will not be paid, forcing the company into
bankruptcy. Liquidity is just as important, and in some situations more
important, than a company’s equity. The nuances between equity and
liquidity are subtle. Equity is a company’s net worth, while liquidity is
how fluid its assets are. Individuals can be similar to corporations; the
term “being house poor” refers to someone with equity in their house, but
with little spendable cash.
Credit lines
Credit lines are available, but unused, potential
loans, designed to meet a company’s day-to-day expenses in a cash crunch.
These loans are normally secured by a company’s receivables or inventories.
Many companies use their credit lines as their main source of liquidity.
When a company’s financial health declines, the credit lines are the first
to disappear. It’s hard to borrow money when you need it. Usually, credit
line terms and bank covenant conditions are not fully disclosed by a
company, leaving investors in a state of limbo. Bank covenants, moreover,
are written to protect the lenders, giving them “wiggle” room to exit a
credit arrangement, if a company’s financial health deteriorates.
Why are bank covenants so important?
The bank covenants are the agreed-upon terms and
conditions of a loan, with which a company must comply. Covenants are put in
place to force a financial discipline on a company.
When a company has bank issues, it normally starts
with a breach of a covenant. That leads to the canceling of credit lines,
which then causes interest payments and other obligations to be missed. This
can cause the banks to call their loans, resulting in the fire sale of
assets, and many times, leading to bankruptcy. Once a company breaches a
covenant, it may snowball into an avalanche. The accounting fees, attorney
fees, investments banking fees, appraisal fees, bank fees, and higher
interest rates can drown a company. The covenants, while not usually
disclosed, are critical. At best, you will find this information in the
company’s SEC disclosures.
Connecting the dots
Many companies do not clearly summarize and explain
their liquidity positions and risks. Investors must tie together a company’s
financial statements, with its lending agreements, to get a complete
liquidity picture. One of the steps is to review a company’s projected cash
flow, along with its working capital position, debt maturity schedule,
credit lines, and capital expenditure requirements, as reported in the
footnotes. By connecting all of the cash flow “dots,” one can identify and
project out tight liquidity periods in advance, thus avoiding a potentially
weak stock.
Enron is the classic example of a company that had a
liquidity failure. I always felt that with Enron, the banks or the
government should have stepped in to provide liquidity and then slowly
downsized or liquidated the firm in a more orderly fashion (similar to how
Long-Term Capital Management was unwound).
Working capital and the current ratio
Working capital represents current assets minus
current liabilities; it is used to help investors identify, early on,
short-term liquidity problems (where a company can not meet its short-term
obligations as they become due). Even positive working capital, however, is
not all-inclusive. It does not take into account the timing of cash inflows
and outflows in a given period; if a mismatch occurs, it can result in a
severe operational workflow bottleneck. (To emphasis this point, it’s
possible to have a large liability payable in January with receivable due in
December of the same year, thus causing a short-term liquidity squeeze.) If
working capital is negative, moreover, it indicates that bank borrowing, new
equity or asset sales may be needed. In most situations, borrowings and new
equity are the hardest to obtain, when needed the most.
A company’s current ratio, defined as current assets
divided by current liabilities, should be between 1 and 2 times. Some
analysts deduct inventory from the current assets when calculating the
current ratio, to get a better picture of a company’s short-term liquidity
position; this is called the quick ratio or acid test. The quick ratio
excludes inventory because it normally takes time, money and effort to
convert it to cash.
Companies normally use their cash on hand and
accounts receivables collections to pay accrued expenses and accounts
payable obligations. Inventory, while also a current asset, is not as liquid
and is harder to turn into cash. A sale needs to occur, and the resulting
receivable collected, before cash becomes available. Overall, a liquidity
mismatch can reduce a company’s financial strength and contribute to a
business failure. If liquidity risk is involved in a stock, one can sell and
wait until profitability and cash flow become more clearly defined before
reinvesting.
Example:
A liquidity crisis is life threatening and can force
a company into bankruptcy, often with little notice. Good examples are
specialty finance companies and mortgage lenders. Usually, their new
business is funded first in a warehouse revolver or commercial paper
facility, then sold and placed in a permanent securitization facility. If
the company’s short-term financing dries up, and its credit lines are
cancelled, the company’s sales/origination functions are effectively shut
down and the company can lose its complete customer base overnight. Customer
relationships that were formed over a company’s lifetime can be severed
instantaneously. In many cases, this creates a snowball effect that leads
into liquidation and/or bankruptcy. The value of a company’s stock can
become worthless, even through the company has earnings and a positive book
value.
Liquidity concerns can decimate a company’s business
and stock price overnight.
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