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Pretty much everybody agrees it will be a tough 2016 for local and global stock markets. But that doesn’t mean we should sell everything and hide out in our bunker – some companies will still manage to do well.
One of the key indicators of a company likely to do better than others is the strength of the company’s balance sheet.
First, a quick reminder of what a balance sheet is and what it tells us.
A balance sheet includes all assets a company has. Assets would include buildings, equipment, stock, cash, monies owed and goodwill (more on goodwill in a moment).
Liabilities are the other side of the balance sheet and include all debts. When subtracting liabilities from assets, one should arrive at a positive value (if not, the company is technically bankrupt).
This value is then the net asset value (NAV) of the company, otherwise known as the company’s book value or the equity value.
With a listed company the calculation is taken further by dividing the NAV by the number of shares to arrive at NAV/share.
A company will trade above this value – investors are not buying the company, but rather the future profits of the company.
The first step is to check that the company’s NAV is positive, but I take it a step further and rather look for the tangible NAV (TNAV).
This TNAV excludes assets such as goodwill. Goodwill occurs when a company buys another company but pays above the NAV for the stock; this higher payment is because, again, future profits are being bought.
The extra payment above NAV is added to the balance sheet as an asset under goodwill.
The concept makes sense, but one has to question whether or not the goodwill can be sold for the same value. That is why I remove goodwill from the equation and use TNAV.
The next step is to determine whether there have been changes in asset valuations. Most equipment will decrease in value as it ages, while buildings may increase in value.
But are the changes modest and in line with previous years’ adjustments? A sudden change may indicate trouble lurking and the company shoring up its balance sheet.
Is cash increasing? The main focus of a company is to generate cash and, while some of this cash will be put back into growing the company and some used for paying dividends, is the cash pile growing?
An exception here may be if another business is bought or a new business is started – this utilisation of cash is one-off and would result in a decreased cash pile.
Also, how does the debt look? How much is current (due within 12 months) and how much of it is long term?
The annual report will give a detailed explanation of all debt; the interest rate, maturity date and whether there are any conditions attached that, if breached, may result in immediate recall of the debt.
Lastly, check how much of the debt is in the form of a bank overdraft. This is expensive debt that can be recalled at any time, which adds risk to the business.
Also look for significant changes year-on-year, look whether management comments on the changes and whether you agree with the comments.
If you don’t, or if management isn’t saying much, you’re better off looking for another stock to invest in.
Finally, I look at the NAV compared to share price. If the long-term relationship is around 2 times and it is currently 1.1 times or maybe 3 times, the question is why. Are we then looking at a bargain or at a business under pressure?
This article originally appeared in the 28 January 2016 edition of finweek. Buy and download the magazine here.
