Balance sheets unlike income statements, are only for a set date. There is no such thing as a balance sheet for the year or quarter. We can create a balance sheet for the year, but it will not only be for that specific date. A company’s of each fiscal quarter. Think of it as a snapshot of the company’s financial condition on the particular date that the balance sheet is generated.
Now a balance sheet is broken into two parts: The first part is all the assets, and there are many different kinds of assets. They include cash, receivables, inventory, property, plant, and equipment.
The second part of the balance sheet is liabilities and shareholders’ equities.
The two correlate as follows:
Total assets = Total Liabilities + Shareholders’ equity (Net worth)
Current Asset Cycle
Current assets are also referred to as the working assets of the business because they are in the cycle of cash going to but inventory; Inventory is then sold to vendors and becomes Trade Receivables, when collected from the vendors, thus turns back into cash.
Cash & Cash Equivalents
A high amount of cash tells one of two things—that a company has a competitive advantage that is generating tons of cash, or that it has just sold a business or a tons of bonds, which may not be a good thing. A low amount of stockpile of cash usually means that a company has a poor economics.
As a general rule:
If we see a lot of cash and little or no debt, chances are very good that the business will sail through the troubled times. But if the company is short of cash and is having large amount of debt, it probably is a sinking ship that not even the most skilled manager can save.
Inventory
Inventory is the company’s products that it has warehoused to sell to its vendors. On balance sheet, the inventory shown is the value of the company’s inventory for that date.
There always a risk of inventory becoming obsolete looming over a lot of businesses. But with a durable competitive advantage company the products that sell never change and therefore never become obsolete.
As a general rule for companies with competitive advantage:
Look for an inventory and net earnings that are on corresponding rise. This indicates company is finding profitable ways to increase their sales, which in turn calls for an increase in inventory.
Trade Receivables
When a company sells its products to a purchaser and the cash is due for payment after month or even a year, the sales in this state of limbo, where the cash is due, are called trade receivables. Receivables as a standalone number tells us very little about the company’s long term competitive advantage.
As a general rule:
Company consistently showing lower ratio of (Net receivables / Total Revenue) than its competitors usually has competitive advantage working in its favour.
Current Ratio
It is defined as the ratio of current assets to current liabilities. Higher the ratio is, the more liquid the company. Current ratio of over one is considered good.
But it isn’t enough in determining the company with competitive advantage, if it is seen alone. Always look for corresponding rise in net earnings, which must be so strong such that it pays off its debt and can offer heavy dividends as well.
Consider a company which has a current ratio of less than 1, doesn’t mean it’s not competitive. May be because it generates heavy cash flows it pays off its debt, or undergoes a share repurchase program which subsequently reduced its current assets, driving the current ratio below 1.
As a general rule:
If Current ratio > 1 Good
If Current ratio < 1 then Net earnings > 3 to 4 (Short term debt)
Property, Plant & Equipment
Companies having Property, plant & equipment incur heavy depreciation and finance costs to maintain them. Moreover companies which are in fiercely competitive industry have to keep their plant equipment and machinery updated to stay competitive.
A company that has a long-term competitive advantage have lesser plant and property, which in turn requires lower maintenance cost to upgrade them.
Some companies because of their product niche keep selling the same product consistently and don’t need to keep updating their machineries.
As a general rule:
Companies having lesser PPE on balance sheet tend to have consistent products thus maximising sales and higher net earnings.
Goodwill
When a company A makes an acquisition of company B by paying in excess of its book value of company B, the excess comes under the company A’s balance sheet as Goodwill.
As a general rule:
Increase in Goodwill means company is acquiring good businesses.
Companies benefiting from competitive advantage don’t sell below their book value.
Intangibles
These are assets we can’t physically touch, include patents, copyrights, trademarks, franchises, brand names etc.
As a general rule:
Companies benefiting from competitive advantage have intangibles which in turn have strong patents & brand value, etc.
Long Term Investments
This is an asset account on a company’s balance sheet, where the value of long-term investments, such as stocks, bonds, real estate is recorded. This account includes investments in the company’s affiliates and subsidiaries.
The long-term investments are carried on the books at their cost or market price, whichever is lower. But it cannot be marked to a price above cost even if the investment value is appreciated.
A company’s long-term investments tell us about the investment mind-set of top management. Do they invest in companies with competitive advantage or do they invest in businesses in highly competitive markets?
Total Assets & Return on Assets (RoA)
Add current assets to non-current assets and we get total assets of the company. These total asset will match its total liabilities, plus shareholders’ equity.
Total assets are important in determining just how efficient the company is in putting its assets to use.
RoA = Net earnings / Total Assets
Higher the RoA the better.
Current Liabilities
Current liabilities are the debts and obligations that the company owns that are coming due within a year. They are found in balance sheet under the headings of Trade Payables, Short term debt, Long term debt due & other current liabilities.
Trade Payable
Trade Payable is money owed to suppliers that have provided goods and services to the company on credit.
Suppose we order one tons of coffee, they send it to us along with a bill/invoice. The bill/invoice for the one ton of coffee is a trade payable.
A large amount of trade payable in current fiscal year means lowering of net earnings in the subsequent years, if the payables are not settled at earliest.
As a general rule:
Payable days should lie between 45 to 90 days.
Short-Term debt
It is the money owed by the corporation and due within the year. Short term debt is always cheaper than the long term debt, which means companies take short term debt from banks and lend it long term. But it poses serious problem like if the bank stops giving short term loans further which means the company need to pay the loan in within a year, but it cannot pay it because it has lend it long term, so it will not be paid for many years. This gimmick can slowly kill companies.
So, a better way to earn is take long term and lend long term.
As a general rule:
Short term Debt / Long term debt < 1
Long-Term Debt Due
Long term debt due is the part of long-term debt to be paid off in the current fiscal year. It should not be confused with short term debt. A company dealing with a large sum of long term debt due in current year, we aren’t dealing with a company that has a competitive advantage. This is serious concern as it can lead to cash flow problems and certain bankruptcy.
As a general rule:
Long-term debt due / Long term debt << 1
Long Term Debt
Companies with competitive advantage often carry little to no long term debt on their balance sheets. This is because these companies are so profitable that they are self-financing when they need to expand a business or make acquisitions, so there never a need to borrow large sums of money.
One way to help us identify the durability of a company is to look at their last 10 years of balance sheets & check for their long term debt loads.
As a general rule:
Long-term debt / Net earnings < 4
Preferred & Common Stocks
They represents ownership in the company. They are the owners of the company and have the right to vote for board of directors, which in turn, will hire a CEO to run the business. Common stock holders receive dividends if the board votes to pay them. And if the entire company is sold, it is the common stockholders who get all the loot.
As a general rule:
Companies with competitive advantage do not have any Preferred & common stocks because they are self-financing and lack any debt.
Retained Earnings
This is by far the most important aspect of finding a company with long-term competitive advantage. Just like net earnings are paid out as dividends, used in share buyback programs, similarly most companies retain the earnings to reinvest them in their company or to make an acquisition.
Retained earnings are calculated by subtracting dividends paid out from the net earnings.
As a general rule:
Companies with competitive advantage retain their net earnings by 90% making them available to reinvest in their company.
Treasury Shares or Buyback Shares
When a company buyback its own shares with a purpose to issuing bthem later it is found in balance under the heading Treasury Shares. It is good sign that a company has confidence in its business operations.
It reduces the overall shareholders’ equity, which in turn increases the per share earnings of the shareholders.
As a general rule:
Companies with competitive advantage are most likely to have them on their balance sheets.
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