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.