Best Penny Stocks For 2017, Top Penny Stocks For 2017: The Balance Sheet Walk Through - The Second Step During My Investment Process

The Balance Sheet Walk Through: The Second Step During My Investment Process

"Volatility is a symptom that people have no idea of the underlying value" - Jeremy Grantham

Many investors and business owners on the most basic level overlook the balance sheet analysis routinely. It is not apparent how important the balance sheet truly is to business operations until liquidity concerns are front and center, threatening to terminate daily operations, followed by creditors pillaging assets. Intelligent investors from the school of Graham&Doddsville understand the importance of the financial statements, more specifically the balance sheet, and the story that is being told. Balance sheet analysis comes second only after the idea generation process and is viewed before both the income statement and cash flow statement during my process.

Solvency

The solvency and liquidity ratios of a firm are of integral importance for both the survival of the firm and creditworthiness of future financing (favorable financing terms may lead to a competitive advantage). The solvency ratios that an intelligent investor should focus on are the current ratio, quick ratio, cash ratio, days of working capital, and interval measure. These ratios show the firms ability to pay the bills in the short-term or how long the firm could last with no future cash-inflows.

The current ratio being the most well known of the bunch, is a measure of the difference between assets that can be converted into cash (in one year or under) and bills or liabilities that are due within the next 365 days. The quick ratio is a form of the current ratio with inventories excluded as inventories can be manipulated (bloated), obsolete, damaged, or lost/stolen and inventories are often the most illiquid current asset. The cash ratio or NWC (net working capital) may be of interest to short-term creditors or in times of stress. A low level (ratio or %) of either would show that the company operates on low levels of liquidity. Da! ys of working capital or the interval measure may be of interest, revealing the length a business could operate on a short-term basis due to a potential strike or other disruption of cash inflows.

· Current Ratio = Current Assets / Current Liabilities

· Quick Ratio = (Current Assets – Inventory) / Current Liabilities

· Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

· Days of Working Capital = (Current Assets – Current Liabilities) / (Annual Expenses / 365)

· Interval Measure = Current Assets / Average Daily Operating Costs (excluding interest and depreciation)

"At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum." – Warren Buffett

The solvency metrics of a business are of importance but it is generally a good idea to dig deeper into the quality and reliability of cash flows in the income and cash flow statements. An example is a company like P&G operating with negative working capital with 24 billion current assets and 30 billion current liabilities or 0.8 current ratio, but due to the reliability of the conversion of inventory to cash and additional sales (from continuing operations) that may be generated in any given quarter, P&G is able to service this debt with ease. (Some companies may need short-term financing due to seasonality of their business model)

Sources and Uses of Cash

During each quarter or year (actually everyday) a company generates cash as well as uses cash, loosely speaking, an increase in assets or decrease in liabilities/equity is a use of cash while a decrease in assets or an increase in liabilities! /equity i! s a source of cash (the difference being net addition or subtraction to cash). The story is not finished there and balance sheet changes must be viewed in combination with the income statement and cash flow statement over multiple time intervals, if one wishes to reveal what is happening in the company. I personally elect to view a mandatory minimum of three years while ideally viewing 7-10+ years.

Asset Management & Turnover (Efficiency Ratios)

Assuming the company that one is analyzing is not forgoing any additional sales, the higher the inventory turnover ratio the more efficient the company is managing its inventory. The longer the days' sales in inventory or lower the inventory turnover ratio the more the company must pay in storage, insurance etc., ultimately lowering the companies gross margins. The average or what is considered normal is roughly 90 days for days' sales in inventory and if the ratio is higher one should investigate for a number of reasons.

Management could have poor financial management skills by over investing in inventory, some of the inventory could be obsolete or facing markdowns, inventory shrink may be a problem, or hopefully the company is just selling a different product mix. Selling is usually characterized when the product is shipped or the service is performed but that does not tell us the terms of the sale or ability to collect on those terms. Receivables turnover and days' sales in receivables reveal the ability to collect while payables turnover shows the length it takes to pay. Longer payable periods result in a cash inflow while longer receivable periods result in a cash outflow.

A great business advantage is one where a company uses negative working capital (due to financing abilities) like Cineplex here in Canada. Cineplex has a near monopoly in the movie theatre business (in Canada) with high margins on concession items and a built in competitive advantage based on how the movies are financed. When someone pays to view a movie ! at Cinepl! ex, they pay for the show immediately before viewing, while Cineplex has an additional 8-12 weeks to pay the production companies, essentially providing a very short-term float and the ability to operate on negative working capital.

The total asset turnover ratio reveals how efficiently the company assets produce cash and should be viewed relative to the fixed asset turnover ratio, enabling an investor to gauge the leverage employed by the company. An investor may also use this information during a scenario analysis/sensitivity analysis; acknowledging fixed costs cannot be forgone, easily.

· Inventory turnover = COGS / Inventory

· Days' sales in inventory = 365 Days / Inventory Turnover

· Receivables turnover = Sales / Accounts Receivable

· Days' sales in receivables = 365 Days / Receivables Turnover

· Net working capital turnover = Sales / NWC

· Total asset turnover = Sales / Total Assets

· Fixed asset turnover = Sales / Fixed Assets

It takes much longer for surplus capacity or inventory to be absorbed than the time it takes demand to exceed supply, leading to longer trough periods and shorter periods of prosperity, due to the fixed nature of production assets and the competitive nature of capitalism (When profit margins are high competition is enticed to enter).

Inventory should also be further viewed with a keen eye, taking notice of raw material, WIP, and finished good trends. Excessive finished goods in relation to raw material or WIP may be a sign of surplus inventory, the opposite being true if raw material and WIP levels are increasing relative to finished goods. One should also be aware of seasonal trends that may lead to additional finished goods being produced (mainly in the third quarter).

Financial Leverage

Financial leverage ratios show how indebted the company is as well as the ability to service the longer-term debt com! mitments.! Total debt should include all outstanding lease agreements and other contractual obligations that will eventually be paid. The cash coverage ratio may be used questionably on a long-term basis if maintenance Capex is not subtracted from EBITDA. Buffett used maintenance Capex metaphorically, and in his example he used the food/nutrition of a human as a parable for maintenance Capex. Buffett explained that it is ok to miss a meal or two or even an entire week but if you miss to many meals in a row, you will starve to death. Personally I prefer simply looking at the interest that will be owed both currently and over the life of the business, in relation to operating income.

· Debt to equity = Total Debt / Total Equity

· Equity multiplier = Total Assets / Total Equity

· Times interest earned = EBIT / Interest Expense

· Cash coverage = EBITDA / Interest

"When you combine ignorance and leverage, you get some pretty interesting results." – Warren Buffett

Market Value Ratios

The book value reveals the "net worth" of a company and the theoretical value that an investor would receive upon liquidation. The ratio can be very miss-leading, but also very helpful, depending on the nature of the business as well as past events that are concealed within the accounting entries. Book value is subject to an entirely other post, specifically the fallibility of book value and owners equity. Enterprise value is characterized as Market Value of equity + market value of interest bearing debt + minority interest – cash and equivalents. A low EV/EBITDA ratio may show that the company (depending on reliability of cash flows) is able to support additional debt (private equity buy-out/LBO) and is used as a proxy for a firm's cash flows and the market value multiple of those cash flows. It is subject to less accounting manipulation thus is more widely used than the P/E ratio by investment bankers and private equity firms.

· B/V = Market Capitalization! / Equity!

· EV/EBITDA = Market Value of equity + market value of interest bearing debt + minority interest – cash and equivalents / Earnings before income tax, depreciation and amortization.

Questions to Ask (From My Checklist)

Looking out 5 to 10 years, how does the company plan to invest cash that is retained in the business? Can receivables be collected more aggressively, payables more lenient? Is some debt uncollectable? Is exhausted equipment being regularly replaced? Are the debts of the company trending up or down?

What is the expected return on equity, on incremental investment? What are the company's plans concerning its capital structure over the next five years: Debt/equity, leasing assets, spinning off capital-intensive assets, off-balance sheet financing? Operating leverage: If sales increase by $1 how much will drop to pre-tax income? Is the receivables cycle lengthening? Are the inventory components forecasting a shortage or surplus?

"It's simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation." – Warren Buffett

About the author:I am working towards the CPA & CFA designations, and would love to manage an investment partnership in the future. I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website

Currently 3.83/512345

Rating: 3.8/5 (6 votes)

Subscribe via Email RSS Feeds

Subscribe RSS Comments Please leave your comment:
More GuruFocus Links

Latest Guru Picks	Value Strategies
Warren Buffett Portfolio	Ben Graham Net-Net
Real Time Picks	Buffett-Munger Screener
Aggregated Portfolio	Undervalued Predictable
ETFs, Options	Low P/S Companies
Insider Trends	10-Year Financials
52-Week Lows	Interactive Charts
Model Portfolios	DCF Calculator
RSS Feed	Monthly Newsletters
The All-In-One Screener	Portfolio Tracking Tool

Best Penny Stocks For 2017, Top Penny Stocks For 2017

Wednesday, January 1, 2014

The Balance Sheet Walk Through - The Second Step During My Investment Process

No comments:

Post a Comment