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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



 Liquidity concerns can decimate a business

Liquidity is a company’s ability to pay its short-term liabilities as they come due. If a company cannot pay its bills, suppliers will stop shipping, customers will squeeze it on price, banks will increase fees, and its employees will not be paid, forcing the company into bankruptcy. Liquidity is just as important, and in some situations more important, than a company’s equity.  The nuances between equity and liquidity are subtle. Equity is a company’s net worth, while liquidity is how fluid its assets are.  Individuals can be similar to corporations; the term “being house poor” refers to someone with equity in their house, but with little spendable cash.

Credit lines

Credit lines are available, but unused, potential loans, designed to meet a company’s day-to-day expenses in a cash crunch. These loans are normally secured by a company’s receivables or inventories. Many companies use their credit lines as their main source of liquidity. When a company’s financial health declines, the credit lines are the first to disappear. It’s hard to borrow money when you need it. Usually, credit line terms and bank covenant conditions are not fully disclosed by a company, leaving investors in a state of limbo. Bank covenants, moreover, are written to protect the lenders, giving them “wiggle” room to exit a credit arrangement, if a company’s financial health deteriorates.  

Why are bank covenants so important?

The bank covenants are the agreed-upon terms and conditions of a loan, with which a company must comply. Covenants are put in place to force a financial discipline on a company.

When a company has bank issues, it normally starts with a breach of a covenant. That leads to the canceling of credit lines, which then causes interest payments and other obligations to be missed. This can cause the banks to call their loans, resulting in the fire sale of assets, and many times, leading to bankruptcy. Once a company breaches a covenant, it may snowball into an avalanche. The accounting fees, attorney fees, investments banking fees, appraisal fees, bank fees, and higher interest rates can drown a company. The covenants, while not usually disclosed, are critical. At best, you will find this information in the company’s SEC disclosures.

Connecting the dots

Many companies do not clearly summarize and explain their liquidity positions and risks. Investors must tie together a company’s financial statements, with its lending agreements, to get a complete liquidity picture. One of the steps is to review a company’s projected cash flow, along with its working capital position, debt maturity schedule, credit lines, and capital expenditure requirements, as reported in the footnotes. By connecting all of the cash flow “dots,” one can identify and project out tight liquidity periods in advance, thus avoiding a potentially weak stock.

Enron is the classic example of a company that had a liquidity failure. I always felt that with Enron, the banks or the government should have stepped in to provide liquidity and then slowly downsized or liquidated the firm in a more orderly fashion (similar to how Long-Term Capital Management was unwound).

Working capital and the current ratio

Working capital represents current assets minus current liabilities; it is used to help investors identify, early on, short-term liquidity problems (where a company can not meet its short-term obligations as they become due).  Even positive working capital, however, is not all-inclusive. It does not take into account the timing of cash inflows and outflows in a given period; if a mismatch occurs, it can result in a severe operational workflow bottleneck. (To emphasis this point, it’s possible to have a large liability payable in January with receivable due in December of the same year, thus causing a short-term liquidity squeeze.) If working capital is negative, moreover, it indicates that bank borrowing, new equity or asset sales may be needed. In most situations, borrowings and new equity are the hardest to obtain, when needed the most.

A company’s current ratio, defined as current assets divided by current liabilities, should be between 1 and 2 times. Some analysts deduct inventory from the current assets when calculating the current ratio, to get a better picture of a company’s short-term liquidity position; this is called the quick ratio or acid test.  The quick ratio excludes inventory because it normally takes time, money and effort to convert it to cash.

Companies normally use their cash on hand and accounts receivables collections to pay accrued expenses and accounts payable obligations. Inventory, while also a current asset, is not as liquid and is harder to turn into cash. A sale needs to occur, and the resulting receivable collected, before cash becomes available. Overall, a liquidity mismatch can reduce a company’s financial strength and contribute to a business failure. If liquidity risk is involved in a stock, one can sell and wait until profitability and cash flow become more clearly defined before reinvesting.


A liquidity crisis is life threatening and can force a company into bankruptcy, often with little notice. Good examples are specialty finance companies and mortgage lenders. Usually, their new business is funded first in a warehouse revolver or commercial paper facility, then sold and placed in a permanent securitization facility. If the company’s short-term financing dries up, and its credit lines are cancelled, the company’s sales/origination functions are effectively shut down and the company can lose its complete customer base overnight. Customer relationships that were formed over a company’s lifetime can be severed instantaneously. In many cases, this creates a snowball effect that leads into liquidation and/or bankruptcy. The value of a company’s stock can become worthless, even through the company has earnings and a positive book value.

Liquidity concerns can decimate a company’s business and stock price overnight.




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