Invest Wisdom

During the last few days I’ve introduced the balance sheet and written about current and long-term assets. Today it’s on to liabilities.

Liabilities (when it comes to balance sheets) is just a fancy word for debt. Just as it is with your own finances, not all debt is bad. Companies have to borrow money just to function.

Current Liabilities

Current liabilities are all debts that are due within the year. While companies can drown in long-term debt, these debts are the most urgent. If a company can’t refinance the debt or come up with a large amount of cash, you can expect a bankruptcy filing to come soon.

You’ll notice that some categories of current liabilities have mirror images on the “assets” side of the balance sheet. Just as a company has accounts receivable, it could have accounts payable, which is money it owes for recent purchases.

Short-term debt is pretty self explanatory. Companies often borrow money for a very short amount of time to account for temporary deficiencies. If, for example, a company just sold several airplanes for several million dollars but it hadn’t collected the money yet, it might need a short-term loan to make payroll.

The market for commercial paper, one example of short-term debt, froze up last year, soon after Lehman Bros. went bankrupt. So even profitable companies were at risk of bankruptcy simply because of timing issues regarding their debt payments.

Long-term debt that is coming due within the year is also a current liability. Unlike, say, a mortgage, where you pay down the debt and pay interest simultaneously, when companies issue bonds, most of the time they pay the interest only. Then, when the debt matures, they pay the principal back.

So if a company issued $100 million in bonds at 6% interest for 30 years, they’d pay those bond holders $6 million a year in interest. But after 30 years, the entire $100 million comes due.

Most of the time, companies can easily refinance that debt at current interest rates. Right now, while the credit market has gotten better, they still might have to accept unfavorable terms for the new loans.

Even if a long-term debt isn’t technically a current liability, it makes sense to check the footnotes of the balance sheet to see when the rest of the debt is coming due. If it’s within the next few years, just understand that that could be a huge, erm, liability for the company as it looks to refinance.

Long-Term Liabilities

This is simply any debt that comes due outside of the year. The less long-term debt you see on the balance sheet, the better. While companies might have to make short-term borrowings all the time, it’s better if you can find companies that don’t have to finance things long-term.

If a company doesn’t carry any long-term debt, it indicates that its earnings power is strong enough that it can self finance major improvements needed for the business. Depending on the industry, this might not be feasible. So you can often glean a lot about a company’s management by comparing debt to other company debt in the industry.

Excessive long-term debt can also come from a leveraged buyout, where the purchaser borrows a ton of money against his target’s current cash flow. The Tribune Company, for example, while very profitable, is under a mountain of long-term debt because of its buyout by Sam Zell.

Other Liabilities

These include deferred income tax and minority interest. Deferred income tax is tax that the company has been able to hold off on paying for one reason or another. Minority interest is shown on the balance sheet when one company has acquired another. If, for example, Coca-Cola bought 90% of Joe’s Soda Shack, it could put 100% of Joe’s assets and liabilities onto its balance sheet. But to show that it didn’t own the entire company, the value of that remaining 10% is filed under Minority Interest.

That’s it. Subtract the total liabilities from the total assets and you get shareholder’s equity (i.e. book value). I’ll explain why that’s important and write about the ratios that investors look at on a balance sheet when I get back on Monday.

— Joe Light

Current assets, which I wrote about on Monday, are those that companies can easily draw upon to pay debt, acquire companies, or give dividends to shareholders. On the other hand, the rest of the assets on the balance sheet aren’t so liquid, but they can be even more important.

Property, plant, and equipment

Most often, these items are the materials and factories that the company needs to make whatever it sells. So if, say, GM owned an auto plant that it used to make trucks, it would carry the cost to build the factory on its balance sheet. Over time, as the factory churns out more trucks, the equipment starts to wear out, and so GM will deduct a little bit of value from this asset every year (this process is known as depreciation).

As the factory depreciates, you can start to anticipate when the company will need to lay out a ton of cash (or borrow a ton of money) to buy a new factory.

But unfortunately, for too many companies, new factories have to be built long before the old ones completely wear out, simply because the company needs to keep up with competitors.

Take a company like Coca-Cola, whose formula hasn’t changed much in decades. Although Coca-Cola could make improvements to its factories to find new cost efficiencies, it doesn’t have to. The Coke you drink today is about the same Coke you drank in 1999.

On the other hand, a company like GM, whose inventory needs to constantly change to keep up with other car companies, will need to retool is factories all the time. I’m not an expert on car manufacturing, but I imagine hybrids require equipment that’s a lot different from plain-old gas guzzlers.

So keep those kinds of competitive advantages in mind when assessing the true value of equipment and property.

Goodwill

Goodwill can be confusing for a lot of investors (including me). When one company buys another company, any excess that the purchasing company paid over the target’s book value is considered to be goodwill.

Let’s say Dino’s Burger Hut has $10 million in tangible assets. Joe of Joe’s Shake Shack decides to buy Dino’s Burger Hut for $20 million, because he recognizes that the Burger Hut’s ongoing profitability is worth more than the assets alone. So Joe puts $10 million in goodwill on his balance sheet.

Companies can adjust the goodwill downward if the business that it purchased has depreciated in value for some reason. You can look at increases in goodwill for evidence that a company is making acquisitions. But when adding up how much a company’s assets will protect you when you buy its bond or stock, always remember that unlike other assets, you can’t sell goodwill.

For a lot more great information about goodwill, take a look at this article.

Intangible Assets

Intangible assets are basically all of those things that you can’t physically touch that make a company valuable: Things such as copyrights, patents, trademarks, brand names, and franchise power. When one company buys another, it can carry the value of those assets at their fair value.

Although they used to be able to, companies can’t carry intangible assets on their balance sheet that they developed in-house. So if Coca-Cola came up with a brilliant new drink formula, it couldn’t simply attach a value to that asset on its balance sheet. But if it acquired a company with the formula, it could. Coke also can’t attach a value to its brand (although very valuable) and carry it as an asset.

Long-term investments

Long-term investments, like stocks and bonds, are valued on the balance sheet at the current market price or at cost, whichever is lower. So even if the market price of the asset has gone up considerably, that won’t be reflected in the balance sheet. That kind of improvement won’t be recorded until the company sells the investment.

For some companies (Warren Buffett’s Berkshire Hathaway for example), the value of the investments is often the greatest asset a company has.

Long-Term Assets + Current Assets = Total assets

I’ll write later on the different ways assets can be compared to earnings to measure a company’s efficiency. But that’s enough to absorb for now. If you want further reading before tomorrow, I recommend checking out Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark. It’s an easy read meant for beginning investors, and I used it myself to double check a lot of this material. Don’t buy it thinking you’ll get some sort of revelation into the way Buffett works. It’s more of an introduction to investing.

On Friday, I’m writing about company liabilities.

— Joe Light

I’m out of the country on vacation all this week (To Spain, thanks for asking!). But rather than leave you with nothing, I’m going to take this blog back to basics again, with an introduction to company balance sheets. Even if you’re a seasoned investor, it helps to be reminded of the earnings statement’s less-favored brother. I hope you pick up a few new things along the way.

A few weeks ago, I gave a basic intro to value investing and tackled the price-to-earnings ratio (P/E), one of the most used measures pulled from a company’s income statement.

For the next several days, I’m going to address the balance sheet, which is just as important. A company could earn $100 million per year in revenues but still go bankrupt if it carries too much debt. The balance sheet can also reveal the value a company carries even if it faces depressed earnings.

Here’s the lineup: Today I’ll introduce the balance sheet and talk about current assets.

On Wednesday, I’ll talk about the rest of the asset side of the balance sheet.

On Friday, it’s on to a company’s debts.

And a week from today, I’ll sum it all up and show some of the other ways it can expose problems or advantages that a company has.
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A primer and a few definitions

Unlike the income statement, which records gains and losses throughout a year or quarter, the balance sheet is a snapshot in time. The balance sheet is a window into what assets and liabilities the company carries at the exact moment that the company drew it up.

You can divide the balance sheet into two parts: a company’s assets, which include cash, receivables, inventory and equipment; and a company’s liabilities and shareholder equity.

Within the liabilities category is “Current Liabilities”, which is debt due within a year, and “Long-Term Liabilities,” which is not.

The shareholder equity of a company, which is the same as net worth, is the total amount of liabilities minus the total debt.

Analyzing the company’s assets

When you begin to look at a balance sheet, it’s good to tackle the assets in two main segments: current assets, and everything else.

Current assets are a company’s most liquid assets and include cash, accounts receivable (i.e. money soon to be paid to the company), and inventory. It helps to think of the current assets line-up as a chain: inventory becomes accounts receivable, accounts receivable becomes cash.

Cash: More is better (duh). But it’s also important to remember that companies with huge piles of cash didn’t always accumulate them from ongoing business. Cash hoards can appear after the sale of a business segment or the issuance of bonds.

If you’re not sure how the company earned the cash it has, you can always look at the last few years of cash balances to see if it accumulated gradually or suddenly. The debt portion of a company’s balance sheet, which we’ll look at on Wednesday, will also reveal if it has issued bonds.

Companies can use cash in several ways. It can be reinvested into the business, used to pay down debt, to give back to investors in the form of stock buybacks or dividends, or to acquire other businesses. Some companies simply like to carry a lot of cash as a kind of emergency fund in case of a rainy day.

Net receivables: Many companies don’t collect payment immediately after selling a product. Instead, the customer will have a certain number of months to pay. Until the customer does, the money is considered a receivable. Of course, some customers will renege on their payment, and for balance sheet purposes, the company estimates how much will never be collected and deducts it from the receivables figure.

Inventory: Inventory is all the goods that a company has already manufactured for sale but that haven’t been sold yet. By itself, it doesn’t tell you much, but look at how the inventory has changed over time, and you can learn how a company is faring.

If earnings are consistently increasing and inventory correspondingly goes up, it means the company is expecting increased demand for its products and has increased manufacturing to keep up. If earnings went up but the inventory went down, it could mean that the company is expecting a drop in business, which could either be because of its own problems or simply because its industry is cyclical. For some companies, like those in the tech business, carrying a lot of inventory is dangerous, because the product could become obsolete.

Other current assets: In most cases, these don’t tell you a ton about a company’s ongoing business but they’re useful to know. They could include prepaid expenses or deferred income tax refunds.

Add all of those components up, and you should get the “Total Current Assets” figure that a company puts on its balance sheet.

On Wednesday, come back to learn about the other assets that a company could have and how you should consider them.

— Joe Light