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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Understanding Financial Statements Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions

Balance Sheet Analysis

 - Leverage and financial
   strength affect share value

 - Liquidity concerns can
   decimate a business

 - Cash is critical, to a point
    * Window Dressing
    * Cash Gap
    * Cash per Share
    * Burn Rate

 - Marketable Securities

 - Receivables are interwoven
    with cash flow
    * Past Dues and Write-offs
    * Receivables turnover ratios
    * Securitizations

 - Inventory - focus on the
   profit margins
    * Perpetual vs. Periodic
    * Inventory Accounting
    * Inventory Costing Methods
    * Lower of Cost of Market
    * Inventory Categories
    * Inventory Turnover Ratios

 - Fixed assets are necessary in
   order to be a world class

 - Liabilities with equity attributes
   are enriching

 - Emphasizing debt net of cash
   can be misleading

 - Book value is a tool to
    properly evaluate a stock

 - Off-balance sheet assets and
    liabilities are legal



Leverage and financial strength affect share value

Leverage is the relationship of borrowing to equity and cash flow. Financial strength, on the other hand, is a company’s ability to meet its financial obligations, under adverse earnings, cash flow, and liquidity conditions. The overall profitability of a company, combined with the degree to which it utilizes leverage, determines its financial strength and credit rating. Normally, the higher the credit rating, the stronger the company. Additionally, a strong company has more opportunities to grow its business, thereby increasing its stock price.

Pros and cons of leverage:

Leverage is said to be a two-edged sword. If the proceeds from the leverage are invested in projects that generate cash flow, and are accretive to earnings, then equity and share value can rise rapidly. Most of your larger companies grow through acquisitions. In effect, they are leveraging their balance sheets. The down side to leverage: when cash flow dries up, equity and control can be lost very quickly.

In financial downturns, management’s decisions can be dictated or influenced by the lenders. Even the fiduciary duty of the board can “flip-flop” and change in favor of the lenders. Tyco experienced the negative effects of being over-leveraged. For example, in July of 2002 Tyco was pressured by its lenders to sell The CIT Group, which it had purchased just a year earlier.

This resulted in a $4.5 billion loss to the Tyco shareholders, even though CIT was a quality franchise that transformed Tyco into a miniature GE. In situations where the lenders pressure companies to quickly sell assets to reduce leverage, the shareholders are usually the losers.   

While leverage provides growth opportunities, it comes with the price tag of increased financial risk and potential equity erosion. 

Why do companies borrow?

Most companies use a balanced mix of debt and equity to fund business opportunities. Many companies prefer debt over equity, because interest paid on debt is tax deductible, while dividend payments to shareholders are made with more costly “after-tax” dollars. Equity investors, moreover, expect a higher rate of return than lenders, due to the extra risk that equity participants take.

It is actually cheaper and easier for management to meet its financial ROE objectives by using debt financing over equity. This is one of the reasons that companies become over-leveraged. Debt dollars are cheaper than equity dollars.

How can investors tell if a company is properly leveraged?

Investors need to ensure themselves that their interest and control will be protected, by reviewing the company’s long-term and short-term leverage. The long term debt to equity ratio measures a company’s leverage; it’s an indication of a company’s ability to meet its long-term debt obligations. Acceptable numbers vary according to industry. Following are several general guidelines:

·        1:2 for small private companies

·        1:1 to 2:1 for larger public companies

·        10:1 to 12:1 for banks

The higher the ratio, the harder it becomes to weather a downturn.

Cash flow to bank debt is another method used to look at a company’s financial strength.

A company, in good and bad times, should be able to: pay its bills as they come due; comply with its bank covenants; have the ability to satisfy its long-term obligations, as scheduled; have an emergency fund available; and have the wherewithal to take advantage of unexpected opportunities as they present themselves.

All other things held constant, a balance sheet is healthier with less debt.

How do companies improve their credit?

When the relationship between management and lenders starts to turn upside down, companies that are over-leveraged use various techniques to strengthen their balance sheet by repaying their debt.

One of the techniques used to improve a company’s financial strength is down/right-sizing. Companies sell assets to pay off the lenders, while hopefully keeping equity intact. Often, however, shareholders’ equity is the extra cushion that companies need to satisfy creditors, if proceeds from asset sales fall short of book value. This can ultimately reduce the future earnings potential and existing share value of a company.

Some companies ask their existing shareholders to help improve their leverage, by issuing common stock rights. Stock rights allow existing shareholders to purchase additional shares at below-market prices, in order to raise equity. While this practice does improve a company’s financial strength, it also dilutes the current shareholders’ percentage of ownership. Those shareholders who elect not to participate in increasing their investment in the company are left with a reduced percentage of the re-capitalized equity. The dilemma for investors is: do they have the wherewithal and interest to purchase the additional shares? Equally important to investors, is the concern that they may be throwing “good money after bad money.” 

For example, in the spring of 2002, Imperial Chemical Industries (“ICI”) successfully raised approximately $1.1 billion from its existing shareholders in an unstable market. The company was able to avoid having its credit rating downgraded. For those investors who never heard of ICI, it is a world class chemical company, that in the late 1990’s reshuffled its product mix out of low margin commodity chemicals into higher margin specialty chemicals, fragrances, flavors, adhesives, starches, and paints. Was its effort a success? Absolutely yes! The company’s stock price is up over eightfold from its low price of $6 in March 2003. 

In many cases, a company’s leverage ratio is matrixed directly with the company’s interest rates on its bank debt.

Can companies have too much equity? Absolutely!

At the opposite end of the debt spectrum are companies with excess equity. While it’s a nice position to be in, it can also have uncertain consequences. Excess equity lowers a company’s ROE percentage and indicates that management is not deploying its resources properly. This seems to be one of Microsoft’s headaches. As a result, Microsoft distributed, in 2004, a one time, $32 billion cash dividend to its shareholders. That’s not a bad perk.

Motorola, additionally, is in the news because it is being targeted by private equity investors trying to get their hands on Motorola’s accumulated cash hoard. In situations like this, private equity investors try to weasel profits (cash) and opportunities away from the smaller shareholders, to themselves. Proper capitalization, therefore, is important and the mix between debt and equity needs to be delicately balanced.

What do you look at?

Young adults should review the composition of the total capitalization structure of their investments: how much of a company is financed by equity versus debt?  In a difficult financial climate, the key concerns always center on the following: (a) does the company have any emergency borrowing capacity, (b) is the company’s cash flow sufficient to pay its bills, (c) does the company have any non-core assets that are worth anything, and (d) if the company needs to down/right size, which assets should be sold first?

When the economy is strong and business is profitable, most investors focus on the P&L. When business is down, or the economy is in a recession, however, it’s the financial strength of the balance sheet that distinguishes a good company from a distressed one. A byproduct of the last recession in 2000 is that companies have reduced their leverage and are holding more cash. Executives now realize that a healthy balance sheet, one with little debt, provides much needed “wiggle” room, in a recession.   

A financially strong balance sheet is insurance protection for investors. Healthy companies have reduced downside risk, and have the ability to weather a storm, and to fight another day.




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