Balance Sheet
“Cash is King”
“Cash is King?” Sure, you have heard this cliche.
You will be talking to another investor about the latest addition to your portfolio and the conversation will turn to how each of you pick stocks. The other investor will smile and wink and say, “Cash is King.” Although somewhat perplexed, you don’t dare ask for clarification for fear of looking like a fool. But what the heck does this really mean?
Publicly traded companies are designed to make money. The conventional way of scoring this pursuit is by looking at the company’s ability to grow various flavors of earnings—operating earnings, pre-tax earnings, net income, and earnings per share (EPS) are all common measures. However, this is not the only way to determine if there is real value in a company’s stock. A company’s real earnings are the earnings that make it from the Consolidated Statement of Earnings to the Balance Sheet as a liquid asset.
Shareholder value ultimately derives from liquid assets, the assets that can easily be converted into cash. A company’s value is determined by how much it can amass in terms of liquid assets.
There are two ways to think about this.
The first is to look at terminal value, which assumes for the sake of calculating potential return that at some future point a company will close down its operations and turn everything into cash, giving the money to shareholders.
The second is to look at where tangible shareholder value comes from-returns on invested capital generated by the company’s operations. If a company has excess liquid assets that it does not need, it can deploy those assets in two ways to benefit shareholders—dividends and/or stock buybacks.
Knowing what is on the balance sheet is crucial to understanding whether or not the company you are investing in is capable of generating real value for shareholders. Most investors who look at annual or quarterly reports spend far too much time worrying about earnings and far too little time worrying about the balance sheet and its cousin, the Statement of Cash Flows. It is the balance sheet that can tell you if a company has enough money to continue to fund its own growth or whether it is going to have to take on debt, issue debt, or issue more stock in order to keep on keeping on. Does a company have to much inventory? Is the company collecting money from its customers in a reasonable amount of time? It is the balance sheet-the listing of all of the assets and liabilities of a company-that can tell you all of this.
Where do you find all this information about the balance sheet? In Singapore, companies are required to send all shareholders an annual report not more than four months past the end of their fiscal year. While this information is 4 months old by the time you see it, it will have been audited by an independent accountant prior to printing.
The financial forms required in Singapore will also be filed with the Registrar of Companies and Businesses ( ROC ), which also gives you online links to such information sites as www.gov/rcb/information and www.commerceasia.com . There are fees associated with retrieving much of this information from the ROC.
If you are researching USA companies, the information is all freely (and instantly) available from Security & Exchange Commission filings at their site edgar . You will find SEC required forms for all listed companies called 10-K and 10-Q.
The 10-K is a toned-down version of the annual report with more text and fewer pretty pictures that comes out once a year, containing the company’s annual balance sheet. The 10-Q is a quarterly filing that a company makes with the SEC three times a year (the 4th being the 10-K) that also tracks the balance sheet through the course of the year.
CURRENT ASSETS
The first major component of the balance sheet is current assets, which are assets that a company has at its disposal that can be easily converted into cash within one operating cycle.
An operating cycle is the time that it takes to sell a product and collect cash from the sale. It can last anywhere from 60 to 180 days. Current assets are important because it is from current assets that a company funds its ongoing, day-to-day operations.
If there is a shortfall in current assets, then the company is going to have to dig around to find some other form of short-term funding, which normally results in interest payments or dilution of shareholder value through the issuance of more shares of stock.
There are five main kinds of current assets-Cash & Equivalents, Short- & Long-Term Investments, Accounts Receivable, Inventories, and Prepaid Expenses.
Cash & Equivalents are assets that are money in the bank, literally cold, hard cash (some prefers to imagine cash as warm and soft, fun to roll around in!) or something equivalent, like bearer bonds, money market funds, or the MDs antique golf clubs. OK-lah, so the antique golf clubs won’t make it past the accountant. Cash & Equivalents are completely liquid assets, and thus should get special respect from shareholders. This is the money that a company could immediately mail to you in the form of a fat dividends–if it had nothing better to do with it (not a great sign, thus many investors don’t look for high dividend stocks). This is the money that the company could use to buy back stock, and thus enhance the value of the shares that you own (investors love this, as it both increases earnings per share on remaining shares, and shows management’s confidence that the shares are a good value—assuming adequate liquidity remains in the shares).
Short-term Investments are a step above cash & equivalents. These normally come into play when a company has so much cash on hand that it can afford to tie some of it up in bonds with durations of less than one year. This money cannot be immediately liquefied without some effort, but it does earn a higher return than cash.
Accounts Receivable, normally abbreviated as A/R, is money that is currently owed to a company by its customers. The reason why the customers owe money is that the product has been delivered but has not been paid for yet. Companies routinely buy goods and services from other companies using credit. Although typically A/R is almost always turned into cash within a short amount of time, there are instances where a company will be forced to take a write-off for bad accounts receivable if it has given credit to someone who cannot or will not pay. This is why you will see something called allowance for bad debt in parentheses beside the accounts receivable number.
Allowance for bad debt is the money set aside to cover the potential for bad customers, based on the kind of receivables problems the company may or may not have had in the past. However, even given this allowance, sometimes a company will be forced to take a write-down for accounts receivable or convert a portion of it into a loan if a big customer gets in real trouble. Looking at the growth in accounts receivable relative to the growth in revenues is important-if receivables are up more than revenues, you know that a lot of the sales for that particular quarter have not been paid for yet. Also look at accounts receivable turnover and days sales outstanding later in this class as another way to measure accounts receivable. Many Asian banks made huge provisions for bad debts, and when those debts were actually paid as the economies recovered they “wrote back” the provisions making their earnings apperar to skyrocket.
Inventories are the components and finished goods that a company has currently stockpiled to sell to customers. Not all companies have inventories, particularly if they are involved in advertising, consulting, services or information industries. For those that do, however, inventories are extremely important. Inventories should be viewed somewhat skeptically by investors as an asset. First, because of various accounting systems like FIFO (first in, first out) and LIFO (last in, first out) as well as real liquidation compared to accounting value, the value of inventories is often overstated on the balance sheet. Second, inventories tie up capital. Companies that have inventories growing faster than revenues or that are unable to move their inventories fast enough are sometimes disasters waiting to happen.
Prepaid Expenses are expenditures that the company has already paid to its suppliers. This can be a lump sum given to an advertising agency or a credit for some bad merchandise issued by a supplier. Although this is not liquid in the sense that the company does not have it in the bank, having bills already paid is a definite plus. It means that these bills will not have to be paid in the future, and more of the revenues for that particular quarter will flow to the bottom line and become liquid assets. Of course, as we’ll learn later—savvy cash flow management (cash flow ratio) involves delaying your payments as long as possible and collecting your debts as soon as possible with minimal inventories along the way.
CURRENT LIABILITIES
Current Liabilities are what a company currently owes to its suppliers and creditors. These are short-term debts that normally require that the company convert some of its current assets into cash in order to pay them off. These are all bills that are due in less than a year. As well as simply being a bill that needs to be paid, liabilities are also a source of assets. Any money that a company pulls out of its line of credit or gains the use of because it pushes out its accounts payable is an asset that can be used to grow the business. There are five main categories of current liabilities: Accounts Payable, Accrued Expenses, Income Tax Payable, Short-Term Notes Payable, and Portion of Long-Term Debt Payable.
Accounts Payable is the money that the company currently owes to its suppliers, its partners and its employees. Basically, these are the basic costs of doing business that a company, for whatever reason, has not paid off yet. One company’s accounts payable is another company’s accounts receivable, which is why both terms are similarly structured. A company has the power to push out some of its accounts payable, which often produces a short-term increase in earnings and current assets.
Accrued Expenses are bills that the company has racked up that it has not yet paid. These are normally marketing and distribution expenses that are billed on a set schedule and have not yet come due. A specific type of accrued expense is Income Tax Payable. This is the income tax a company accrues over the year that it does not have to pay yet according to various tax schedules. Although subject to withholding, there are some taxes that simply are not accrued by the government over the course of the quarter or the year and instead are paid in lump sums whenever the bill is due.
Short-Term Notes Payable is the amount that a company has drawn off from its line of credit from a bank or other financial institution that needs to be repaid within the next 12 months. The company also might have a portion of its Long-Term Debt come due within a year, which is why this gets counted as a current liability even though it is called long-term debt-one of those little accounting quirks.
DEBT & EQUITY
The remainder of the balance sheet is taken up by a hodge-podge of items that are not current, meaning that they are either assets that cannot be easily turned into cash or liabilities that will not come due for more a year.
Specifically, there are five main categories-Total Assets, Long-Term Notes Payable, Stockholders/Shareholder’s Equity, Capital Stock, and Retained Earnings.
Total Assets are assets that are not liquid, but that are kept on a company’s books for accounting purposes. The main component is plants, property and equipment and encompasses any land, buildings, vehicles and equipment that a company has bought in order to operate its business. Much of this is actually subject to an accounting convention called depreciation for tax purposes, meaning that the stated value of the total assets and the actual value or price paid might be very different.
Long-Term Notes Payable or Long-Term Liabilities are loans that are not due for more than a year. These are normally loans from banks or other financial institutions that are secured by various assets on the balance sheet, such as inventories. Most companies will tell you in a footnote to this item when this debt is due and what interest rate the company is paying.
The last main component, Stockholder’s Equity is composed of Capital Stock and Retained Earnings. Frankly, this is more than a little bit confusing and does not always add all that much value to the analysis. Capital stock is the par value of the stock issued that is recorded purely for accounting purposes and has no real relevance to the actual value of the company’s stock. Capital in Excess of Stock is another weird accounting convention that is pretty difficult to explain. Essentially, it is any additional cash that a company gets from issuing stock in excess of par value under certain financial conventions.
Retained earnings is another accounting convention that basically takes the money that a company has earned, less any earnings that are paid out to shareholders in the form of dividends and stock buybacks, and records this on the company’s books. Retained earnings simply measure the amount of capital a company has generated and is best used to determine what sorts of returns on capital a company has produced. If you add together capital stock and retained earnings, you get shareholder’s equity-the amount of equity that shareholders currently have in the company.
