A look at a few pointers to a weak balance sheet

IMENTIONED last week that one of the linchpins in Anthony Bolton’s investment success was careful balancesheet analysis. “The job of a professional investor is as much about avoiding disasters as it is about picking winners,” Fidelity’s former fund manager said, “and the stocks that have been my biggest disasters over the years nearly always had weak balance sheets.”

It raises the question: what is a weak balance sheet? The most common answer is likely to involve debt and the most popular ratio used to measure financial health is probably the debt to equity ratio.

The way to calculate it is supposedly self-explanatory — total liabilities divided by shareholders’ equity — and the lower the ratio the better. But in practice things are never that easy.

The composition of equity and debt and its influence on the value of the firm is much debated. When used to calculate a company’s financial leverage, the debt usually includes only long-term debt. Some financial analysts exclude certain types of liabilities, such as accounts payable. Adjustments are sometimes also made, for example, to exclude intangibles.

What does it matter? Sometimes it does and sometimes it doesn’t. WG Wearne, for example, on August 31 last year had longterm debt of R248,4m on equity of R39,6m, resulting in a debt to equity ratio of 6,3. Including further net liabilities of R63,4m pushes the ratio up to 7,9. Both figures are sufficiently bad that it doesn’t really matter which approach is used.

But 1Time, in December last year, had long-term debt of R16m on equity of R87,8m, resulting in a ratio of 0,2. But, with the addition of net current liabilities of R295m and a deferred tax liability of R77,4m, the ratio becomes 4,2, highlighting a significant problem.

The current ratio is equally popular and determines how easily a company can pay off its shortterm debt. It is calculated by dividing current assets by current liabilities; the first being assets that can be liquidated within a year, the other liabilities that fall due within a year. A current ratio of one or more is acceptable, but the higher the better. 1Time, therefore, with current assets of R147,6m and current liabilities of R442,6m, resulting in a current ratio of 0,3, was in a precarious situation in December last year — and probably even more so today.

The quick ratio is the current ratio, excluding inventories. It is arguably a better representation of financial soundness as inventories can often take longer than a year to liquidate. Calgro M3, for example, with current assets of R479,8m on current liabilities of R340,3m, has a current ratio of 1,4. But take out inventories of R249,3m and you are left with a quick ratio of 0,7.

Besides the accounting-type ratios, there are three other obvious red flags of financial distress:

Negative retained earnings: retained earnings represent a company’s cumulative net income. Negative retained earnings indicate that a company has generated accounting losses over a prolonged period of time. Companies that have recently released results with negative retained earnings include Buildmax, Erbacon, Moneyweb, Nutrition, Rockwell and Santova,

Negative net tangible assets: usually caused by an excess of goodwill. Intangibles usually have an accounting value that exceeds their economic value. Consequently, at some point they necessitate an amortisation charge, in the case of goodwill, or a revaluation cost, in the case of other intangibles. Erbacon, with intangibles of R129,4m on equity of R95,1m, has a negative tangible asset value of 17,7c.

Negative equity: when the deficit in retained earnings surpasses equity the company is in significant distress. So much so that it usually has only two options: to recapitalise by issuing new shares, or file for bankruptcy. Alert Steel has negative equity of R11,1m, or 0,6c per share, and is trying to raise R120m through a rights offer of 4,3-billion shares at 2,8c per share.

As Bolton says, you need to invest in growing companies to make decent returns.

However, often the faster companies grow, the harder they fall. Companies pursuing helter-skelter growth tend to burn through cash at a frightening rate, often because of essential expenditures.

“So watch out for balance sheets that are growing rapidly — the overall ‘net assets’ figure is a reasonable benchmark — particularly if cash balances are being hammered and net debt is rising fast.

“I am always surprised how little analysis of balance sheets is done by most equity analysts,” says Bolton.

“Often I will read a report on a company I know to have a pretty weak balance sheet and no reference will be made to this at all.

“I think most investors could gain from a better understanding of the risks they are taking when they buy shares of companies that have weak balance sheets.”