Lesson 3 Material Analyzing a Balance Sheet Introduction How many times have you flipped to the back of a company's annual report and found yourself blankly staring at the pages of numbers and tables? You know that these should be important to your investing decision, but you're not quite sure what they mean or where to begin. In Lesson 3, we're going to take our first major step towards changing that. Smart investors have always known that financial statements are the keys to every company. They can warn of potential problems, and when used correctly, help determine what a business is really "worth". An investor who understands financial statements will never have to ask "is this company a good investment?". For every business, there are three important financial statements you must look at; the Balance Sheet, the Income Statement, and the Cash Flow Statement. The balance sheet tells investors how much money the company has, how much it owes, and what is left for the stockholders. The cash flow statement is like a business' checking account; it shows you where the money is spent. The income statement is a record of the company's profitability. It tells you how much money a corporation made (or lost). In this lesson, we are going to learn to analyze a balance sheet. There are two segments: in the first, we will go through a typical balance sheet and explain what each of the items means. In the second, we will actually look at the balance sheets of several American corporations and perform basic financial calculations on them. How to Get a Copy of a Company's Balance Sheet Since you can't do your analysis without a balance sheet, you're going to have to get your hands on one. How do you get a company's financial statements? Generally, you should look in one of three places. 1.) The Annual Report: The annual report is a document released by companies at the end of their fiscal year which includes almost everything an investor needs to know about the business. It generally contains pictures of facilities, branch offices, employees, and products [all of which are completely unimportant to making your investing decision.] They are normally followed by a letter from the CEO and other senior management which discusses the past as well as upcoming year. Tucked away in the back of most annual reports is a collection of financial documents. Most of the time you can go onto a company's website and find the Investor Relations link. From there, you should be able to either download the annual report in PDF form or find information on how to contact shareholder services and request a copy in the mail. 2.) The 10K: This is a document filed with the SEC which contains a detailed explanation of a business. It is reported annually and contains the same financial statements the annual report does, in a more detailed form. The benefit of the 10K is that it allows you to find out additional information such as the amount of stock options awarded to executives at the company, as well as a more in-depth discussion of the nature of the business and marketplace. Sometimes you will find that a company has no financial statements in the 10K, but instead has written, "incorporated herein by reference" This means that the financial statements can be found elsewhere [such as in the annual report or another publication]. Even if this is the case, it is still worth it to get a copy. You can find this by contacting the company, visiting their website, or going to FreeEdgar (freeedgar.com) or SEC.gov. 3.) The 10q: The is similar to the 10k, but is filed quarterly [four times a year - normally the end of January, June, September, and December]. If the company is planning on changing its dividend policy, or something equally as important, they may bury it in the 10q. These documents are critical and can be obtained in the same way as the annual report and 10k. You will want to get a copy of all three documents for the past year or two from the company you are interested in investing in. Most of them can be found at http://finance.yahoo.com - type in the ticker symbol of the company you want to research and then click the "financials" link. This will bring up a copy of the latest quarterly financial statements. (For all good purposes, I would recommend you first analyze the annual balance sheet, which can be found by clicking "annual data" in the upper right hand corner.) Another excellent source of financial statements is The Street. As always, it is best to get the information directly from the company. What is a Balance Sheet? Pretend that you are going to apply for a loan to put a swimming pool into your backyard. You go to the bank asking to borrow money, and the banker insists that you give him a list of your current finances. After going home and looking over your statements, you pull out a blank sheet of paper and write down everything you have that is of value [your checking and savings account, mutual funds, house, and cars]. Then, at the bottom of the sheet your write down all of your debt [the mortgage, car payments, and your student loan]. You subtract everything you owe by all the stuff you have and come up with your net worth. Congratulations, you just created a balance sheet. Just as the bank asked you to put together a balance sheet to evaluate your credit-worthiness, the government requires companies to put them together several times a year for their shareholders. This allows current and potential investors to get a snapshot of a company's finances. Among other things, the balance sheet will show you the value of the stuff the company owns [right down to the telephones sitting on the desk of their employees], the amount of debt, how much inventory is in the corporate warehouse, and how much money the business has to work with in the short term. It is generally the first report you want to look at when valuing a company. Before you can analyze a balance sheet, you have to know how it is set-up. Note: Unlike other financial statements, the balance sheet cannot cover a range of dates. In other words, it may be good "as of December 31, 2002", but can't cover from December 1 - December 31. This is because a balance sheet lists items such as cash on hand and inventory, which change daily. Assets, Liabilities and Shareholder Equity Every balance sheet is divided into three main parts - assets, liabilities, and shareholder equity. Assets are anything that have value. Your house, car, checking account, and the antique china set your grandma gave you are all assets. Companies figure up the dollar value of everything they own and put it under the asset side of the balance sheet. Liabilities are the opposite of assets. They are anything that costs a company money. Liabilities include monthly rent payments, utility bills, the mortgage on the building, corporate credit card debt, and any bonds the company has issued. Shareholder equity is the difference between assets and liability; it tells you the "book value", or what is left for the stockholders after all the debt has been paid. Every balance sheet must "balance". The total value of all assets must be equal to the combined value of the all liabilities and shareholder equity (i.e., if a lemonade stand had $10 in assets and $3 in liabilities, the shareholder equity would be $7. The assets are $10, the liabilities + shareholder equity = $10 [$3 + $7]). What Does a Balance Sheet Look Like? Below is an example of what a typical balance sheet looks like. Coca-Cola Company Consolidated Balance Sheet - January 31, 2001 Assets Current Assets Dec. 31, 2000 Dec. 31, 1999 Cash and Cash Equivalents $1,819,000,000 $1,611,000,000 Short Term Investments $73,000,000 $201,000,000 Receivables $1,757,000,000 $1,798,000,000 Inventories $1,066,000,000 $1,076,000,000 Prepaid expenses and other $1,905,000,000 $1,794,000,000 Total Current Assets $6,620,000,000 $6,480,000,000 Long Term Assets Long Term Investments $8,129,000,000 $8,916,000,000 Property, Plant and Equipment $4,168,000,000 $4,267,000,000 Goodwill $1,917,000,000 $1,960,000,000 Intangible Assets N/A N/A Accumulated Depreciation (or Amortization) N/A N/A Other Assets N/A N/A Deferred Long Term Asset Charges N/A N/A Total Assets $20,834,000,000 $21,623,000,000 Liabilities Current Liabilities Accounts Payable $9,300,000,000 $4,483,000,000 Short Term Debt $21,000,000 $5,373,000,000 Other Current Liabilities N/A N/A Total Current Liabilities $9,321,000,000 $9,856,000,000 Long-Term Liabilities Long Term Debt $835,000,000 $854,000,000 Other Liabilities $1,004,000,000 $902,000,000 Deferred Long Term Liability Charges $358,000,000 $498,000,000 Minority Interest N/A N/A Total Liabilities $11,518,000,000 $12,110,000,000 Shareholder's Equity Misc. Stock Option Warrants N/A N/A Redeemable Preferred N/A N/A Preferred Stock N/A N/A Common Stock $870,000,000 $867,000,000 Retained Earnings $21,265,000,000 $20,773,000,000 Treasury Stock ($13,293,000,000) ($13,160,000,000) Capital Surplus $3,196,000,000 $2,584,000,000 Other Stockholder Equity ($2,722,000,000) ($1,551,000,000) Total Stock Holder Equity $9,316,000,000 $9,513,000,000 Net Assets $7,399,000,000 $7,553,000,000 Current Assets The first thing listed under the asset column on the balance sheet is something called "current assets". This is where companies list all of the stuff that can be converted into cash in a short period of time [usually a year or less]. Because these assets are easily turned into cash, they are sometimes referred to as "liquid". They normally consist of: Cash and Cash Equivalents Cash and Cash Equivalents is the amount of money the company has in bank accounts, savings bonds, certificates of deposit, and money market funds. It tells you how much money is available to the business immediately. How much should a company keep on the balance sheet? Generally speaking, the more cash on hand the better. Not only does a decent cash hoard give management the ability to pay dividends and repurchase shares, but it can provide extra wiggle-room when times get bad. There are some cases where cash on the balance sheet isn't necessarily a good thing. If a company is not able to generate enough profits internally, they may turn to a bank and borrow money. The money sitting on the balance sheet as cash may actually be borrowed money. To find out, you are going to have to look at the amount of debt a company has (we will be discussing this later on in the lesson). The moral: You probably won't be able to tell if a company is weak based on cash alone; the amount of debt is far more important. Short Term Investments These are investments that the company plans to sell shortly or can be sold to provide cash. Short term investments aren't as readily available as money in a checking account, but they provide added cushion if some immediate need were to arise. Short Term Investments become important when a company has so much cash sitting around that it has no qualms about tying some of it up in slightly longer-term investment vehicles (such as bonds which have maturities of less than one year). This allows the business to earn a slightly higher interest rate than if they stuck the cash in a corporate savings account. Perhaps the most legendary cash hoard in the business world right now is Microsoft's - the company has $5.25 billion in cash and $32.973 billion in short term investments. Receivables Also sometimes known as "Account Receivables", this is money that is owed to a company by its customers. Here's how it works: Let's say Wal-Mart wants to order a new DVD which is being released by Warner Brothers. Wal-Mart orders 500,000 copies for its stores. Warner Brothers receives the order, and within a week, ships the DVDs to one of Wal-Mart's warehouses. Included in the shipment is a bill (let's say WB charged Wal-Mart $5 per DVD for half a million copies - that's $2.5 million). Warner Brothers has already sent the movies to Wal-Mart, even though Wal-Mart hasn't paid a penny. In essence, Wal-Mart is buying on credit and promising to pay WB's the $2.5 million. The $2.5 million would go on Warner Brother's balance sheet as receivables. Generally a company that sells a product on credit sets a term. The term is the number of days customers must pay their bill before they are charged a late fee or turned over to a collection agency (most terms are, 30, 60 or 90 days). If Warner Brothers sold the DVDs to Wal-Mart on a 30 day term, Wal-Mart must pay its bill during that time. While accounts receivable are good, they can bring serious problems to a business if they aren't handled properly. What if Wal-Mart went bankrupt or simply didn't pay Warner Brothers? WB would then be forced to write down its receivables on the balance sheet by $2.5 million. This is what is called a delinquent account. Normally, companies build up something called a reserve to prepare for situations such as this. Reserves are set amounts of money that are taken out of the profits each year and put into an account specifically designed to act as a buffer against possible loses the company may incur. (Reserves are touched on in Part 29). When customers don't pay their bills, companies can take money out of the reserve they had built up to pay back suppliers. Receivable Turns Common sense tells you the faster a company collects its receivables, the better. The sooner customers pay their bills, the sooner a company can put the cash in the bank, pay down debt, or start making new products. There is also a smaller chance of losing money to delinquent accounts. Fortunately, there is a way to calculate the number of days it takes for a business to collect its receivables. The formula looks like this: Credit Sales (found on the income statement - not the balance sheet) -------------------------(divided by)--------------------------- Average Receivables Let's look at an example. H.F. Beverages Balance Sheet (Excerpt) 2000 1999 Receivables $1,183,363 $1,178,423 Income Statement (Excerpt) Credit Sales $15,608,300 H.F. Beverages* is a major manufacturer of soft drinks and juice beverages. It sells to supermarkets and convenience stores across the country on a 30 day term. To see if customers are paying on time, we need to look for the income statement. It is normally found within a page or two of the balance sheet in the annual report or 10K. With the income statement in front of you, look for an item called "Credit Sales" (if you can't find it, there is an item called "Total Sales" which is acceptable but not as accurate). In 2000, H.F. Beverages reported credit sales of $15,608,300. If we look at the excerpt from its balance sheet (above), we will see that in 2000, it had $1,183,363 in receivables and in 1999, $1,178,423. We need to find out the average amount of receivables H.F. had in 2000, so we would take $1,1873,363 + $1,178,423 and divide it by 2. The answer is $1,180,893. Plug the two numbers into the formula. Credit Sales = $15,608,300 ------------(divided by)-------------- Average Receivables = $1,180,893 The answer, called "Receivable Turns" by financial analysts, is 13.2173. This means that H.F. Beverages collects its accounts receivable 13.2173 times per year. Once you calculate this number, finding out the number of days it takes for customers to pay their bills is simple. Since there are 365 days in a year and the company gets 13.2173 turns per year, take 365 ÷ 13.2173. The answer is the number of days it takes the average customer to pay (in H.F.'s case, we come up with 27.61). This means the company is doing a good job managing its accounts receivable because customers aren't exceeding the 30 day policy. Had the answer been greater than 30, you would have been wise to try to find out why there were so many late payments, which could be a sign of trouble. (Keep in mind you will need to read through the company's reports to find out what its collection deadline is. Not all companies require their customers to pay within 30 days). *A Fictional Company for illustration only Inventories When looking at a company's current assets, you need to pay special attention to inventory. Inventory consists of merchandise a business owns but has not sold. It is classified as a current assets because investors assume that inventory can be sold in the near future, turning it into cash. To come up with a balance sheet amount, companies must estimate the value of their inventory. For instance, if Nintendo had 5,000 units of its new video game system, the Game Cube, sitting in a warehouse in Japan, and expected to sell them to retailers for $300 each, they would be able to put $1,500,000 on their balance sheet as the value of their current inventory (5000 units x $300 each = $1.5 million). This presents an interesting problem. When inventory piles up, it faces two major risks. The first is the risk of obsolesce. In another year, few stores will probably be willing to buy the Game Cube video game system for $300 simply because a newer, faster, and better system may have come along. Although the inventory is carried on the balance sheet at $1.5 million, it may actually lose value as time passes. When you hear that a company has taken an inventory write-off charge, it means that management essentially decided the products that were sitting in storage or on the store shelves weren't worth the values they were stated at on the balance sheet. To correct this, the company will reduce the carrying value of its inventory. If a year passes and Nintendo still has 3000 of the 5000 units in storage, the executives may decide to lower their prices hoping to sell the remaining inventory. If they lower the Game Cube's price to $200 each, they would have 3000 units at $200. Before, those 3000 units were stated at a value of $900,000 on the balance sheet. Now, because they are selling for less, the same units are only worth $600,000. The risk of obsolesce is especially present in technology companies or manufacturers of heavy machinery. Another inventory risk is spoilage. Spoilage occurs when a product actually goes bad. This is a serious concern for companies that make or sell perishable goods. If a grocery store owner overstocks on ice cream, and two months later, half of the ice cream has gone bad because it has not been purchased, the grocer has no choice but to throw it out. The estimated value of the spoiled ice cream must be taken off the grocery store's balance sheet. The moral of the story: the faster a company sells its inventory, the smaller the risk of value loss. Inventory Turn Before you invest, you are going to have to make an informed decision about how much you think the inventory is really worth. A major part of this decision should be based on how fast the inventory is "turned" (or sold). Two competing companies may each have $20 million sitting in inventory, but if one can sell it all every 30 days, and the other takes 41 days, you have less of a risk of inventory loss with the 30 day company. Finding out how fast a company turns its inventory is simple. Here's the formula: Current Year's Cost of Goods Sold or Cost of Revenues (found on the income statement - not the balance sheet) ----------------------------------------(Divided By)------------------------------------------ The average inventory for the period Let's look at a real-world example: Coca-Cola Balance Sheet (Excerpt) 2000 1999 Inventories $1,066,000,000 $1,076,000,000 Income Statement (Excerpt) Cost of $6,204,000,000 Goods Sold The cost of goods sold is $6,204,000,000. The average inventory value between 1999 and 2000 is $1,071,000,000 (average the values from 1999 and 2000). Plug them into the formula. Current Year's Cost of Goods Sold = $6,204,000,000 ----------------------(divided by)---------------------- Average Inventories = $1,071,000,000 The answer is the number of inventory turns - in Coca-Cola's case, 5.7927. What this means is that Coca Cola sells all of its inventory 5.79 times each year. Is this good? To answer this question, you must find out the average turn of Coke's competitors and compare. If you do the research, you find out that the average turnover of a company in Coke's industry is 8.4. Why is Coca-Cola's turn rate lower? Should it affect your investing decision? The only way you can answer these kinds of questions is if you truly understand the business you are analyzing. This is why it is important that you read the entire annual report, 10k and 10q of the companies you have taken an interest in. Although Coke's turn rate is lower, further analysis of the balance sheet will reveal that it is 4 to 5x financially stronger than its industry averages. With such outstanding economics, you probably don't need to worry about inventory losing value. Let's take the inventory analysis a step further. Once you have the inventory turn rate, calculating the number of days it takes for a business to clear its inventory only takes a few seconds. Since there 365 days in a year and the Coca Cola clears its inventory 5.7927 times per year, take 365 ÷ 5.7927. The answer (63.03) is the number of days it takes for Coke to go through its inventory. This is a great trick to use at cocktail parties; grab a copy of an annual report, scribble the formula down and announce loudly that "Wow! This company takes 63 days to sell through its inventory!" People will instantly think you are an investing genius. The number of days a company should be able to sell through its inventory varies greatly by industry. Retail stores and grocery chains are going to have a much higher inventory turn rate since they are selling products that generally range between $1 and $50. Companies that manufacture heavy machinery such as airplanes, are going to have a much lower turn over rate since each of their products may sell for millions of dollars. Hardware companies may only turn their inventory 3 or 4 times a year, while a department store may do twice that, turning at 6 or 7. If you want to compare the inventory turnover rate of a company to its competitors, you can go to MSN Money Central. Inventory in Relation to Current Assets When analyzing a balance sheet, you also want to look at the percentage of current assets inventory represents. If 70% of a company's current assets are tied up in inventory and the business does not have a relatively low turn rate (less than 30 days), it may be a signal that something is seriously wrong and an inventory write-down is unavoidable. 1 It is acceptable to use the total sales instead of the cost of sales. The cost of sales is a more accurate reflection of inventory turn and should be used for the truest results. When comparing the company to others in its industry, make sure you use the same number. You cannot value one company using cost of sales, and another using total sales. McDonald's vs. Wendy's: An Example It's easy to see how a higher inventory turn than competitors translates into superior business performance. McDonalds is unquestionably the largest and most successful fast food restaurant in the world. Let's compare it to one of its main competitors, Wendy's. McDonalds 2000 1999 Inventories $99,300,000 $82,700,000 Cost of $8,750,100,000 Revenue Wendy's 2000 1999 Inventories $40,086,000 $40,271,000 Cost of $1,610,075,000 Revenue Use the inventory turn formula [cost of sales or cost of revenue divided by the average inventory values] to come up with the number of inventory turns for each business. Between 1999 and 2000, McDonalds had an inventory turn rate of 96.1549 [incredible for even a high-turn industry such as fast food]. This means that every 3.79 days, McDonald's goes through its entire inventory. Wendy's, on the other hand, has a turn rate of 40.073 and clears its inventory every 9.10 days. This difference in efficiency can make a tremendous impact on the bottom line. By tying up as little capital as possible in inventory, McDonalds can use the cash on hand to open more stores, increase its advertising budget, or buy back shares. It eases the strain on cash flow considerably, allowing management much more flexibility in planning for the long term. The Final Word on Inventory The bottom line: investors want as little money as possible tied up in inventory. It is fine to have a lot of inventory on the balance sheet if it is being sold at a fast enough rate there is little risk of becoming obsolete or spoiled. Great companies have excellent inventory handling systems so they only order products when they are needed - they never buy too much or too little of something. Businesses that have too much inventory sitting on the shelves or in a warehouse are not being as productive as they could be: had management been wiser, the money could have been kept as cash and used for something more productive. *Note: These financials were taken from Yahoo! finance on 02/09/02 Prepaid Expenses In the course of every day operations, businesses will have to pay for goods or services before they actually receive the product. If a jewelry store moved into your neighborhood mall, it would most likely have to sign a rent agreement and pay six to twelve months' rent in advance. If the monthly rent was $1,000 and the business prepaid for an entire year, they would put $12,000 on the balance sheet under Prepaid Expenses ($1,000 monthly rent x 12 months = $12,000). Each month, they would deduct 1/12 from the prepaid expenses until the end of the year, at which point, the amount would be $0. Sometimes companies decide to prepay taxes, salaries, utility bills, rent, or the interest on their debt. These would all be pooled together and put on the balance sheet under this heading. By their very nature, Prepaid Expenses are a small part of the balance sheet. They are relatively unimportant in your analysis and shouldn't be given too much attention. Notes Receivable Notes Receivable are debts owed to the company which are payable within one year. Other Current Assets Other current assets are non-cash assets that are owed to the company within one year. Non Standard Items Sometimes companies put items on their balance sheet which aren't standard. If you find yourself analyzing a balance sheet and an oddball term shows up, search for it at investorwords or investopedia. If that still doesn't work, you can call your broker or a local banker, all of whom should be happy to give you an explanation of a term. I would recommend you get a copy of Barron's "Dictionary of Finance and Investing Terms" ( ). They are relatively inexpensive ($10 or $11), and define over 4,000 terms. This can be a huge asset regardless of the financial statement you are looking at. You may also find the "Dictionary of Business Terms" useful as well. It has 7,500 entries covering almost every business definition you could possibly ask for ( ). While neither is required to do balance sheet analysis, they can be a big help. Current Liabilities Current liabilities are the debts a company owes which must be paid within one year. They are the opposite of current assets. Current liabilities includes things such as short term loans, accounts payable, dividends and interest payable, bonds payable, consumer deposits, and reserves for Federal taxes. Let's take a look at some of the most common and important ones. Accounts Payable Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it. Accrued Benefits / Payroll This is money owed to employees as salary and bonus that the company has not yet paid. Short Term and Current Long Term Debt These items are sometimes referred to as notes payable. They are the most important item under current liabilities. Most of the time, they represent a company's bank loans. Borrowing money in itself is not necessarily a sign of financial weakness; an intelligent department store executive may work out short term loans at Christmas so she can stock up on merchandise before the Holiday rush. If demand is high, the store would sell all of its inventory, pay back the short term loans, and pocket the difference. This is known as utilizing leverage. The department store used borrowed money to make a profit. So how can you ever hope to tell if a company is wisely borrowing money (such as our department store), or recklessly going into debt? Look at the amount of notes payable on the balance sheet (if they aren't classified under 'notes payable', combine the company's short term obligations and long term current debt.) If the amount of cash and cash equivalents is much larger than the notes payable, you shouldn't have any reason to be concerned. If, on the other hand, the notes payable has a higher value than the cash, short term investments, and accounts receivable combined, you should be seriously concerned. Unless the company operates in a business where inventory can quickly be turned into cash, this is a serious sign of financial weakness. Other Current Liabilities Depending on the company, you will see various other current liabilities listed. Sometimes they will be lumped together under the title "other current liabilities." Normally, you can find a detailed listing of what these "other" liabilities are buried somewhere in the annual report or 10k. Often, you can figure out the meaning of the entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly confident the amount listed is what will be paid out to the company's bond holders in the short term. Consumer Deposits If you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the current liabilities called "Consumer Deposits". Often, they will be will lumped under other current liabilities. This is the amount that customers have deposited in the bank. Since, theoretically, all of the account holders could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability. Working Capital The number one reason most people look at a balance sheet is to find out a company's working capital (or "current") position. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company's position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt. Working Capital is the easiest of all the balance sheet calculations. Here's the formula: Current Assets - Current Liabilities = Working Capital One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time. Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available. A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties. Working Capital per Dollar of Sales To find the approximate amount of working capital a company should have, you should look at "working capital per dollar of sales." In other words, you are going to have to compare the amount of working capital on the balance sheet to the total sales (which is found on the income statement - not the balance sheet). A business that sells a lot of low-cost items, and cycles through its inventory rapidly (a grocery store) may only need 10-15% of working capital per dollar of sales. A manufacturer of heavy machinery and high-priced items with a slower inventory turn may require 20-25% working capital per dollar of sales. A company such as Coca Cola would probably fall somewhere between the two. Here's the formula for Working Capital per Dollar of Sales Working Capital -------------------------(divided by)--------------------------- Total Sales (Found on the Income Statement) Let's look at an example: Goodrich, Inc. (Symbol GR) Goodrich provides systems for aircraft as well as manufacturers heavy-duty engines. Working Capital: $933,000,000 (current assets - current liabilities) Total Sales (found on the income statement) = $4,363,800,000 Let's plug the numbers into the formula: Working Capital = $933,000,000 -------------------------(divided by)--------------------------- Total Sales (Found on the Income Statement) = $4,363,800,000 The answer for Goodrich is .2138, or 21.38%. As a manufacturer of heavy duty machinery, GR falls within the 20-25% working capital per dollar of sales range. This is good. Negative Working Capital Some companies can generate cash so quickly they actually have a negative working capital. This is generally true of companies in the restaurant business (McDonalds had a negative working capital of $698.5 million between 1999 and 2000). Amazon.com is another example. This happens because customers pay upfront and so rapidly, the business has no problems raising cash. In these companies, products are delivered and sold to the customer before the company ever pays for them. Don't understand how a company can have a negative working capital? Think back to our Warner Brothers / Wal-Mart example. When Wal-Mart ordered the 500,000 copies of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the country? By the twentieth day, they may have sold all of the DVDs. In the end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesn't really need to have enough cash on hand to pay all of its accounts payable. As long as the transactions are timed right, they can pay each bill as it comes due, maximizing their efficiency. The bottom line: A negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis). In any other situation, it is a sign a company may be facing bankruptcy or serious financial trouble. Buying a Company for Free If you can buy a company for the value of its working capital, you essentially pay nothing for the business. Going back to our Goodrich example; the company has $933 million in working capital. There are currently 101.9 million shares outstanding, which means each share of Goodrich stock has $9.16 cents worth of working capital. If GR's stock was trading for $9.16, you would basically be purchasing the stock for free (paying $1 for each $1 the company had in its checking account, inventory, etc.). You would pay nothing for the company's fixed assets (such as real estate, computers, & buildings) and earnings. For the past ten or twenty years, it has been incredibly rare for a company to trade that low. You can still use the basic concept to your advantage; if you can find a business that is trading for working capital plus half the value of the fixed assets, you would be paying $0.50 for every $1.00 of assets. Current Ratio The current ratio is another test of a company's financial strength. It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year. You can find the current ratio by dividing the total current assets by the total current liabilities. For example, if a company has $10 million in current assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2). An acceptable current ratio varies by industry. Generally speaking, the more liquid the current assets, the smaller the current ratio can be without cause for concern. For most industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls below 1 (which means the company has a negative working capital), you will need to take a close look at the business and make sure there are no liquidity issues. Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash. If this is not the case and a company's number is low, you should be seriously concerned. Inefficiency If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you may want to be concerned. A number this high means that management has so much cash on hand, they may be doing a poor job of investing it. This is one of the reasons it is important to read the annual report, 10k and 10q of a company. Most of the time, the executives will discuss their plans in these reports. If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to try to find out what is going on. As I mentioned earlier, Microsoft current has the biggest cash hoard in the business world. It's current ratio is in excess of 4. The company has no long term debt on the balance sheet. What are they planning on doing? No one knows; the software giant may pay a dividend for the first time, pour the money back into research and development, or buy back shares. Although not ideal, too much cash on hand is the kind of problem a smart investor prays for. Quick Test Ratio The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is the most excessive and difficult test of a company's financial strength and liquidity. To calculate the quick ratio, take the current assets and subtract the inventory (current assets minus inventory is often referred to as the "quick assets"). What you are left with are the items that can be converted into cash immediately . Divide the result by the current liabilities. The answer is the Quick Test ratio. What does this tell you? It is a reflection of the liquidity of a business. The Quick Test ratio does not apply to the handful of companies where inventory is almost immediately convertible into cash (such as McDonalds, Wal-Mart, etc.) Instead, it measures the ability of the average company to come up with cold, hard cash literally in a matter of hours or days. Since inventory is rarely sold that fast in most businesses, it is excluded. Long Term Assets Everything we've discussed up until now has been a current asset or liability. Now, we are going to take a look at the long term assets that are found on the balance sheet. These are the things that a business owns but can't be used to fund day-to-day operations. Long Term Investments Long Term investments and funds are investments a company intends to hold for more than one year. They can consist of stocks and bonds of other companies, real estate, and cash that has been set aside for a specific purpose or project. In addition to investments a company plans to hold for an extended period of time, Long Term Investments also consist of the stock in a company's affiliates and subsidiaries. The difference between Short Term and Long Term investments lie in the company's motive for owning them. Short term investments consist of stocks, bonds, etc. a company has bought and will sell shortly. The investments made under long term investments may never be sold. An excellent example would be Berkshire Hathaway's relationship with Coca-Cola. Berkshire owns 200 million shares of the soft-drink giant, and will most likely continue to hold them forever, regardless of the price they are selling for in the open market. Carrying Values of Stock Investments As you now know, when a business purchases common stocks as an investment, they will go into either the Short Term or Long Term Investment categories on the balance sheet. These are normally carried on the balance sheet at cost or market value (whichever is less). This means that most of the time, the stocks the company owns are worth far more than they are on the balance sheet (for example, if a business owned 50,000 shares of Sprint and they paid $10 per share, they would have $500,000 on the balance sheet under either short term or long term investments. If Sprint rose to $35 per share, the value of their holdings would be $1,750,000, yet the balance sheet would continue to carry $500,000. Thus, the difference of $1,250,000 would not be included in the book value of the company. (This is a prime example of how financial statements are only the beginning of the valuation process. They have their limitations, but without them, we would have no basis to calculate intrinsic value.) Property, Plant and Equipment These are referred to as "fixed assets". In other words, these are the corporation's real estate, buildings, office furniture, telephones, cafeteria trays, brooms, factories, etc. They are the physical assets the company owns but can't quickly convert to cash. Depending on the type of business, these may or may not make up a large percentage of the total assets. Most of the assets of a railroad or airline will fall into this category (these companies must continue to buy railroad cars and planes to survive - both of which are fixed assets). An advertising agency on the other hand, will have far fewer fixed assets. They require nothing but their employees, some pencils, and a few computers. You must be careful not to pay too much attention to this number. Since companies are often unable to sell their fixed assets within any reasonable amount of time (who would be willing to buy 3 notebook binders, a factory, the broom in the broom closet, etc. at a moment's notice?) they are carried on the balance sheet at cost regardless of their actual value. It is possible for companies to grossly inflate this number (which is called "watering" the stock), or to write the values down to nothing (some companies have $1 million dollar buildings carried for $1 on the balance sheet). When analyzing a balance sheet, you will want to look at this number with a raised eyebrow. Don't completely ignore it (that would be foolish), but certainly don't take it too seriously. Intangible Assets Companies often own things of value that cannot be touched, felt, or seen. These consist of patents, trademarks, brand names, franchises, and economic goodwill (which is different than the accounting goodwill we've discussed. Economic goodwill consists of the intangible advantages a company has over its competitors such as an excellent reputation, strategic location, business connections, etc.) While every effort should be made for businesses to carry them at costs on the balance sheet, they are normally given completely meaningless values. To prove the point that the intangible value assigned on the balance sheet can be deceptive, here's an excerpt from Michael F. Price's introduction to Benjamin Graham's "The Interpretation of Financial Statements"... In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max Heine asked me to look at a small brewery - the F&M Schaefer Brewing Company. I'll never forget looking at the balance sheet and seeing a +/- $40 million net worth and $40 million in 'intangibles'. I said to Max, 'It looks cheap. It's trading for well below its net worth.... A classic value stock!' Max said, 'Look closer.' I looked in the notes and at the financial statements, but they didn't reveal where the intangibles figure came from. I called Schaefer's treasurer and said, 'I'm looking at your balance sheet. Tell me, what does the $40 million of intangibles related to?' He replied, 'Don't you know our jingle, 'Schaefer is the one beer to have when you're having more than one.'?' That was my first analysis of an intangible asset which, of course, was way overstated, increased book value, and showed higher earnings than were warranted in 1975. All this to keep Schaefer's stock price higher than it otherwise would have been. We didn't buy it." When analyzing a balance sheet, you should generally ignore the amount assigned to intangible assets. These intangible assets may be worth a huge amount in real life (Coca-Cola's brand name is priceless), but it is the income statement, not the balance sheet, that gives investors insight into the value of these intangible items. Goodwill In the accounting sense, Goodwill can be thought of as a "premium" for buying a business. When one company buys another, the amount they pay is called the purchase price. Accountants take the purchase price and subtract it by a company's book value. The difference is called Goodwill. (There is a review of book value in Part 27.) When a company buys another company, they can use one of two accounting methods: pooling of interest or purchase. When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created. When the purchase method is used, the acquiring company will put the premium they paid for the other company on their balance sheet under the "Goodwill" category. Accounting rules require the goodwill be amortized over the course of 40 years. What does that mean? Let's use McDonalds and Wendy's as an example since most people are familiar with them. McDonalds Earnings: $1,977,300,000 Shares Outstanding: 1.29 Billion (You don't need McDonalds other information for this example) Wendy's Book Value: $1,082,424,000 Book Value per Share: $10.3482 Shares Outstanding: 104.6 Million Earnings: $169,648,000 Say McDonalds decided to buy all of Wendy's stock using the purchase method. Wendy's has a book value of $10.3482 per share, yet is trading at $32 per share. If McDonalds were to pay the current market price, they would spend a total of $3,347,200,000 (104.6 million shares x $36 per share). To keep this example simple, we are going to assume the shareholders of Wendy's approved the merger for cash. McDonalds would mail a check to the Wendy's shareholders, paying them $32 for each share they owned. Since the book value of Wendy's is only $1,082,424,000, and McDonalds paid $3,347,200,000, McDonalds paid a premium of $2,264,776,000. This is going to go onto their balance sheet as Goodwill. It is required to be amortized against earnings for up to 40 years. This means that each year, 1/40 of the goodwill amount must be subtracted from McDonalds' earnings so that by the 40th year, there is no goodwill left on the balance sheet. Now that McDonalds and Wendy's are one company, their earnings will be combined. Assuming next year's results were identical, the company would earn $2,146,948,000, or $1.66 per share 1. Remember that goodwill must be amortized, meaning 1/40 the amount must be deducted from next year's earnings. McDonalds must deduct $56,619,400 from earnings next year as a charge against goodwill 2. Now, McDonalds can only report earnings of $2,090,328,600, or $1.62 per share (compared to the $1.66 they would have been able to report before the goodwill charge). Goodwill reduced earnings by 4¢ per share. If the pooling of interest method had been used, no goodwill would have been created, and McDonalds would have reported EPS (earnings per share) of $1.66. Meaning that depending on how the accounting was handled, the exact same transaction could have two vastly different impacts on earnings per share. It is no wonder that managements, in order to avoid this reduction in reportable earnings, frequently opt to use the pooling of interest method when they complete a merger. Since no goodwill is created, over- eager managers are able to pay outrageous prices for acquisitions with little or no accountability on the balance sheet. Since it makes no sense to have two different ways for accounting for a merger, the FASB (the folks in charge of coming up with these accounting rules) decided they should eliminate the pooling of interest method and force all transactions to be done via the purchase method. Executives and politicians claimed this will significantly reduce the number of mergers since the new standards would cause reportable earnings to drop as soon as a company had completed an acquisition. As a concession, the FASB will no longer require goodwill to be written off unless the assets became impaired (which means it becomes clear that the goodwill isn't worth what the company paid for it). Pay careful attention to the mergers a company has made in the past few years. Once you are able to value a business, you will want to look at recent acquisitions to determine if they were too expensive. If you find this to be the case, you will probably want to avoid the stock (why would you want to invest in a company that was throwing your money around?). Notes: 1.) Since McDonalds purchased Wendy's, the two companies' profits will be combined. $1,977,300,000 + $169,648,000 = $2,146,948,000. To get the earnings per share, you would simply divide it by the number of shares outstanding (1.29 billion). We're assuming McDonalds bought Wendy's for cash. If stock had been used, the number of shares would change, but for simplicity sake, we are going to assume this not to be the case. 2.) Take the premium $2,264,776,000 and divide it by 40 years = this is the charge against earnings each year 3.) Companies purchased before 1970 are not required to be amortized off the balance sheet. They can stay there forever. Other Assets Other Assets are non-cash assets which are owed to the company for a period longer than one year. Deferred Long Term Asset Charges These are expenses which the company has paid for but not yet subtracted from the assets. They are very similar to Prepaid Expenses (where rent would be counted as an asset until it came due each month, then would be subtracted from the balance sheet). In fact, Prepaid Expenses are type of deferred charge. The difference is, when companies prepay rent or some other expense, they have a legal right to collect the service. Deferred Long Term Asset Charges have no legal rights attached to them. For example, if a company prepaid rent on a storage building, and then spent $30,000 moving all of their equipment into it, they could set the $30,000 up on the balance sheet as a deferred charge. This way, they wouldn't be forced to take a hit by reducing their earnings $30,000 the same month they paid for the relocation costs. They could then write this amount down over time. These charges are intangible and should be given very little weight when analyzing a balance sheet. Long Term Debt The amount of long term debt on a company's balance sheet is crucial. It refers to money the company owes that it doesn't expect to pay off in the next year. Long term debt consists of things such as mortgages on corporate buildings and / or land, as well as business loans. A great sign of prosperity is when a balance sheet shows the amount of long term debt has been decreasing for one or more years. When debt shrinks and cash increases, the balance sheet is said to be "improving". When it's the other way around, it is said to be "deteriorating". Companies with too much long term debt will find themselves overwhelmed with interest payments, a risk of having too little working capital, and ultimately, bankruptcy. Thankfully, there is a financial tool that can tell you if a business has borrowed too much money. Debt to Equity Ratio The Debt to Equity Ratio measures how much money a company should safely be able to borrow over long periods of time. It does this by comparing the company's total debt (including short term and long term obligations) and dividing it by the amount of owner's equity (which is explained in part 23. For now, you only need to know that the number can be found at the bottom of the balance sheet. You'll actually calculate the debt to equity ratio in segment two when we look at real balance sheets.) The result you get after dividing debt by equity is the percentage of the company that is indebted (or "leveraged"). The normal level of debt to equity has changed over time, and depends on both economic factors and society's general feeling towards credit. Generally, any company that has a debt to equity ratio of over 40 to 50% should be looked at more carefully to make sure there are no liquidity problems. If you find the company's working capital, and current / quick ratios drastically low, this is is a sign of serious financial weakness. Profitable Borrowing If a business can earn a higher rate of return than the interest rate at which it borrows, it becomes profitable for the business to borrow money. (An example: If a corporation earned 15% on its investments and borrowed funds at 8%, it would make 7% on the borrowed money [15% return - 8% cost of money = 7% net profit]. This boosts what analysts call "Return on Equity". We will talk about Return on Equity, or ROE, in a future lesson. It is briefly touched on in the Retained Earnings section of this lesson.) Other Liabilities Like the few other "other" parts of the balance sheet, "Other Liabilities" is a catch-all category where companies can consolidate their miscellaneous debt. You can normally find an explanation of what makes up these other liabilities somewhere in the financial reports. Often times, they consist of things such as inter-company borrowings (where one of a company's divisions or subsidiaries borrows from another), accrued expenses, sales tax payable (in the instance of retail stores), etc. Generally, you should take the time to look at the various other liabilities a company has. Most are self explanatory and are not as important as the other major liabilities already discussed. Minority Interest When you look at a balance sheet, you will see an entry called "Minority Interest". This refers to the equity of the minority shareholders in a company's subsidiaries. An example will help clarify. In 1983, Nebraska Furniture Mart was the most successful home furnishings store in the United States. It's gross annual sales exceeded $88.6 million, and the company had no debt. At the time, Warren Buffett, the CEO of Berkshire Hathaway, was searching for great businesses to acquire. After noticing how successful the furniture business appeared to be, he approach the owner, Rose Blumpkin, and offered to buy the company. Almost immediately, Rose offered to sell 90% of Nebraska Furniture Mart to Berkshire for $55 million. The next day, Buffett walked into the store and handed her a check. This made NFM a partially-owned subsidiary of Berkshire. (A subsidiary is a company controlled by another company through ownership of at least a majority of the voting stock.) Since subsidiaries are controlled by their parent companies, accounting rules allow for them to be carried on the parent company's balance sheet 1. When Berkshire bought its 90% stake in Furniture Mart, it was able to add the assets of the furniture giant to its own balance sheet. This presents a problem. Berkshire can now add the assets of Nebraska Furniture Mart to its balance sheet, but technically, it doesn't own them all. Remember, Rose Blumpkin only sold 90% of her company - she kept the other 10%. Berkshire will somehow have to show that some of the assets on its balance sheet belong to Rose, who has a minority interest in NFM. To do this, it will calculate the value of Rose's stake in the subsidiary and put it under a liability account called "Minority Interest". These are the assets Berkshire "owes" Rose. A company may have several minority partners in many subsidiaries. The minority interest of all of these partners is added together and placed on the balance sheet. 1 A company can integrate the balance sheet of its subsidiary if it owns 80% or more. It can report earnings of the subsidiary if it owns 20% or more. Shareholder Equity Shareholder Equity is the net worth of a company. It represents the stockholders' claim to a business's assets after all creditors and debts have been paid. Shareholder equity is also referred to as Owner's or Stockholders' Equity. It can be calculated by taking the total assets and subtracting the total liabilities. Shareholder equity usually comes from two places. The first is cash paid in by investors when the company sold stock; the second is retained earnings, which are the accumulated profits a business has held on to and not paid out to its shareholders as dividends. Because these are the two ways a company generally creates shareholders' equity, the balance sheet is organized to show each parts' contribution. Book Value Book Value and Shareholder Equity are not quite the same thing. To find a company's book value, you need to take the shareholders' equity and exclude all intangible items. This leaves you with the theoretical value of all of the company's tangible assets (those which can be touched, seen, and felt). For this reason, book value is sometimes also called "Net Tangible Assets". Net Tangible Assets (or Book Value) The amount of net tangible assets a company has is particularly important. Since you should always analyze the balance sheet you get directly from the company (as opposed to the ones you find on Yahoo or other financial sites), you may not always have this figure calculated for you. To calculate it, take the total assets and subtract all of the intangible assets such as goodwill. What you are left with is the nuts and bolts of the company; the buildings, computers, telephones, pencils, and office chairs. In the past, it was generally thought the more assets a company had the better. Over the past twenty years, value investors have come to reject this idea in its pure form; it is actually preferable to own a business that generates earnings on a lower asset base. Why? Let's say your company earns $10 million a year and has $30 million in assets. My company earns the same $10 million but has $50 million assets. It is generally understood that a relationship exists between the amount of assets a company has and the profit it generates for the owners. If you wanted to double the earnings of your company, you would probably have to invest another $30 million into the company. After the reinvestment, the business would have $60 million in assets and earn $20 million a year. On the other hand, if I wanted to double the earnings of my company, I would have to invest another $50 million into the business (which would double the assets). After the reinvestment, my business would have $100 million in assets and generate $20 million a year. What does that mean? You would have to retain $30 million in earnings to double your profits. I would have to retain $50 million to get the same profit! That means that you could have paid out the difference (in this case $20 million) as dividends, reinvested it in the business, paid down debt, or bought back shares! We will talk more about this in the future. Common, Preferred, and Convertible Shares You'll normally see an entry for such things as "common" or "preferred" stock on the balance sheet under the shareholder's equity section of a balance sheet. This does not refer to the current price of all of the company's shares. Instead, these entries reflect the par value of the company's stock, and / or, when there is no par value assigned to the stock, the amount investors paid when the company issued shares. What is par value? Par was originally created as a way to protect creditors and shareholders by providing a "cushion" of assets that could not be damaged or impaired. In time, it proved to be completely unsuccessful at protecting either party. This is important because companies would take the total shares outstanding, multiply them by the par value, and put them on the balance sheet as "paid in capital". An example: if a business had 100,000 shares of stock outstanding and each had a par value of $1, the company would put $100,000 under "common stock" on the shareholder equity part of the balance sheet. Eventually, state governments no longer required companies to establish a par value on their stock. In cases where no par exists, a corporation must put the amount raised when the company issued stock. If the same business had 100,000 shares and no par, but it initially sold stock at $25 per share, it would put $2,500,000 under the common stock section of shareholder equity on the balance sheet. On most balance sheets, there is a list of such entries. They consist of all of the capital that has been paid in by shareholders who have purchased either the common stock, preferred stock, warrants, etc. Capital Surplus To understand what Capital Surplus is, you must first understand the concept of Surplus. From an accounting standpoint, surplus is the difference between the total par value of the stock outstanding and the shareholder equity and Proprietorship Reserves. (Don't panic! It's not as complicated as it sounds!) You already know what par value and shareholder equity are. The only thing you haven't learned about is Proprietorship Reserves, which we will discuss in a minute. Almost always part of the surplus is a result of retained earnings (which would increase the shareholder equity). There is a specific part of the surplus that comes from other sources (such as increasing the value of fixed assets carried on the balance sheet, the sale of stock at a premium, or the lowering of the par value on common stock). These "other" sources are frequently called "Capital Surplus" and placed on the balance sheet. In other words, Capital Surplus tells you how much of the company's shareholder equity is not due to retained earnings. Reserves & Proprietorship Reserves Reserves deserve special attention when analyzing a company. Although we aren't going to discuss them in depth until a later lesson, it would be wise to lightly touch on them so you have a general understanding of their purpose. When a business creates a "Reserve", they are essentially setting aside a certain amount of money for a specific purpose. Often times, reserves are monies set aside to act as a buffer against future losses. Let's look at a few examples: If a company had a substantial amount of their current assets in receivables, they would set aside money in case some of the customers didn't pay their bills. This is a reserve for doubtful and bad accounts. If a business had a build up of inventories that risked losing their value, management would create a reserve to offset losses. If a manufacturing corporation decided to save money to build a new widget plant, they would put money in a reserve until they had saved enough to pay for it. Proprietorship Reserves are set up to alert investors that a certain part of the shareholder's equity cannot be paid out as cash dividends since they have another purpose. Treasury Stock When analyzing a balance sheet, you're apt to run across an entry under Shareholder Equity called "Treasury Stock". This refers to the shares a company has issued and somehow reacquired either through share repurchase programs or donations. Companies sometimes buy back their shares for a variety of reasons. In most cases, it is a sign management believes the stock is undervalued. Depending upon its objectives, a company can either retire the shares it purchases, or hold them with the intension of reselling them to raise cash when the stock price rises. When a corporation purchases its own stock, the cash on hand is reduced. This lowers the total shareholder equity. In order for investors to know the reduced cash and equity was a result of share repurchases and not debt or losses, management puts the cost of the reacquired stock under "Treasury Stock" in order to clarify. This is why you will often see a negative number besides the treasury stock entry. (You may be wondering why the current market price of the company's treasury stock isn't listed as an asset (since the shares can be sold at any time to raise cash). There is a debate about this in the accounting world. The premise is that all unissued stock can also be sold for cash yet it isn't listed as an assets - treasury stock should be treated the same way.) Many states limit the amount of treasury stock a corporation can own at any given time since it is way of taking resources out of the business by the owners / shareholders, which in turn, may jeopardize the legal rights of the creditors. Retained Earnings When a company generates a profit, management has one of two choices: they can either pay it out to shareholders as a cash dividend, or retain the earnings and reinvest them in the business. When the executives decide that earnings should be retained, they have to account for them on the balance sheet under Shareholder Equity. This allows investors to see how much money has been put into the business over the years. Once you learn to read the income statement, you can use the retained earnings figure to make a decision on how wisely management is deploying and investing the shareholder's money. If you notice a company is plowing all of its earnings back into itself and isn't experiencing exceptionally high growth, you can be sure that the stock holders would be better served if the board of directors declared a dividend. Ultimately, the goal for any successful management is to create $1 in market value for every $1 of retained earnings. Let's look at an example: Microsoft has retained $18.9 billion in earning over the years. It has over 2.5 times that amount in stockholder equity ($47.29 billion), no debt, and earned over 12.57% on its equity last year. Obviously, the company is using the shareholder's money very effectively. With a market cap of $314 billion, the software giant has done an amazing job. Lear Corporation is a company that creates automotive interiors and electrical components for everyone from General Motors to BWM. As of 2001, the company had retained over $1 billion in earnings and had a negative tangible asset value of $1.67 billion dollars! It had a return on equity of 2.16%, which is less than a passbook savings account. The company is astronomically priced at 79.01 times earnings and has a market cap of $2.67 billion. In other words: Shareholders have reinvested a billion dollars of their money back into the company and what have they gotten? They owe $1.67 billion.1 That is a bad investment. The Lear example deserves a closer look. It is immediately apparent that shareholders would have been better off had the company paid out its earnings as dividends. Unfortunately, the economics of the company are so bad had the profits been paid out, the business probably would have gone bankrupt. The earnings are reinvested at a sub par rate of return. An investor would earn more on the earnings by putting them in a CD or Money Market fund then by reinvesting them into the business. 1 You may be wondering how the company has a supposed book value of $23.77 per share, and yet the shareholders owe a billion and a half dollars. If you look at Lear's balance sheet, you will notice it shows shareholder equity of $1.6 billion and tangible assets of -1.665 billion. This doesn't look as horrible as it is until you discover $3.27 billion of the assets on the company's balance sheet consist of goodwill. The shareholders' equity is being inflated by the goodwill figure - without it, the shareholders are left owing money to the company's creditors. Formulas & Calculations for the Balance Sheet You've learned how to analyze a balance sheet! In Segment 2 we are going to work through the balance sheets of a few American companies. Here is a reference guide for all of the calculations you've learned so far. You should memorize these as soon as possible; they are priceless investment tools for the rest of your life. Tests of a Company's Financial Strength and Liquidity: Working Capital: Current Assets - Current Liabilities Working Capital per Dollar of Sales: Working Capital ÷ Total Sales1 Current Ratio: Current Assets ÷ Current Liabilities Quick / Acid Test / Current Ratio: Current Assets minus inventory (called "Quick Assets) ÷ Current Liabilities Debt to Equity Ratio: Total Liabilities ÷ Shareholders' Equity Tests of a Company's Efficiency: Receivable Turnover: Net Credit Sales1 ÷ Average Net Receivables for the Period Average Age of Receivables: Numbers of days in period ÷ Receivable Turnover Inventory Turnover: Cost of Goods Sold1 ÷ Average Inventory for the Period Number of Days for Inventory to Turn: Number of days in Period ÷ Inventory Turnover 1 These can be found on the income statement, not the balance sheet. Putting it all Together: What the Balance Sheet Can and Cannot Tell You Once again, congratulations. You now have the tools necessary to analyze a balance sheet. Before you go running out wielding your new-found power of fundamental analysis, you have to understand the limitations of the balance sheet. If I were going to sell you the local grocery store or corner gas station, you would not make an offer based solely on the balance sheet. Instead, you would take into consideration the profit the business generated, the future prospects for the business, the local competition, etc. That is precisely what you are doing when you look at a publicly traded company; you must make a decision just as if you were purchasing a private business. The balance sheet is just one key in making that decision; it is the theoretical value of the enterprise if you were to purchase it, liquidate the assets, and shut its doors. The liquidation value is not the true value of a business - what is important is how much cash it can generate for the owners in the future. Only in exceptionally rare cases (where a company is trading for less than its working capital, for instance) could you make an investment decision based solely on the balance sheet. Often times, the information you find on the balance sheet isn't valuable in and of itself; it must be compared with something else. There were a few calculations we looked at that required the use of the income statement (which is the focus of Lesson 4). As you progress through these lessons, you will find that by using the three financial statements together, you can garner nearly all of the secrets of any business. Now, get ready to put your skills to the test. We're going to analyze a few balance sheets together. Balance Sheet 1: Microsoft The main purpose of balance sheet analysis is to determine if a company is financially strong and economically efficient. The first balance sheet we are going to look at is a perfect example of both. It can be found in Microsoft's 2001 10K statement. (Note that an excerpt from the income statement is provided so you can calculate receivable and inventory turns). You need to keep this information in front of you as we analyze. I recommend you either print this page or open it in a new browser window. Balance Sheet - 2001 (In millions) June 30 2001 2000 Assets Current assets: Cash and equivalents $ $ 3,922 4,846 Short-term investments 18,952 27,678 Total cash and short-term investments 23,798 31,600 Accounts receivable 3,250 3,671 Deferred income taxes 1,708 1,949 Other 1,552 2,417 Total current assets 30,308 39,637 Property and equipment, net 1,903 2,309 Equity and other investments 17,726 14,141 Other assets 2,213 3,170 Total assets $52,150 $59,257 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ $ 1,188 1,083 Accrued compensation 557 742 Income taxes 585 1,468 Unearned revenue 4,816 5,614 Other 2,714 2,120 Total current liabilities 9,755 11,132 Deferred income taxes 1,027 836 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital—shares authorized 23,195 28,390 12,000; shares issued and outstanding 5,283 and 5,383 Retained earnings, including accumulated other comprehensive income of $1,527 and $587 18,173 18,899 Total stockholders’ equity 41,368 47,289 Total liabilities and stockholders’ equity $52,150 $59,257 Income Statement (In millions, except earnings per share) Year Ended June 30 1999 2000 2001 Revenue $19,747 $22,956 $25,296 Operating expenses: Cost of revenue 2,814 3,002 3,455 A Quick Note on Microsoft's Balance Sheet Before we begin analyzing, notice that unlike most balance sheets, the most recent year is on the right hand side in bold. I highlighted the column so you would be sure to look at the correct figures. An additional point: when companies put together their balance sheet, they tend to omit the 000's at the end of long numbers to save space. If you see on the top of a balance sheet that numbers are stated "in thousands", add "000" to find the actual amount (i.e., $10 stated in thousands would be $10,000). If a balance sheet is stated in millions, you will need to add "000,000" (i.e., $10 stated in millions would be $10,000,000). Keep in mind we are analyzing the fiscal balance sheet as of June, 2001. This information may be different when you go to search on Moneycentral, Yahoo!, or TheStreet since they will use the most recent data available. The purpose of this analysis is not to advice you on what to buy, but rather to show you the process of analyzing a balance sheet. Let's Begin Analyzing! Cash Position The first thing you will notice is that Microsoft has $31.6 billion in cash and short term investments. This doesn't mean much unless you compare it to the company's debt to find out if it is borrowed money. Glance down the balance sheet and look for any long-term debt. You'll notice there isn't an entry for it. This isn't a mistake; Microsoft has no long term debt. Don't get too excited yet. Remember that some businesses fund day-to-day operations with short-term loans (think back to our department store executive at Christmas in Part 10). To see if Microsoft is using short term debt to survive, look at the current liabilities. In 2001, the entire value of Microsoft's current liabilities was $11,132. Compare that to the $31.6 billion in cash the company has. Does it have enough money to pay off its debt? Absolutely. Microsoft's balance sheet has 3x the cash necessary to pay off current liabilities and long term debt. This is without calculating in receivables and other assets. You can be sure the company is not in any danger of going bankrupt. Working Capital Let's calculate the company's working capital. Take the current assets ($39,637) and subtract the current liabilities ($11,132). The answer is $28,505. Microsoft has $28.5 billion in working capital. To find the working capital per share, look at the bottom of the balance sheet. You'll see there are 5.383 billion shares outstanding. Take the working capital of $28.5 billion and divide it by the 5.383 billion shares outstanding. The answer, $5.29, is the amount of working capital per-share. If you could buy Microsoft's stock at $5.29 per share, you would be getting all of the company's fixed assets (real estate, computers, long term investments, etc.) plus its earnings / profit each year from now until eternity for free! The company will probably never trade that low; but you should always keep this in mind when analyzing a business. Sometimes, especially during serious economic downturns, you will find companies selling close to working capital. (Note: We will discuss stock option dilution and other advanced concepts in later lessons.) Working Capital per Dollar of Sales We calculated working capital at $28.505 billion. According to Microsoft's income statement, total revenue (the same thing as total sales) came to $25.296 billion. Following the formula for Working Capital per Dollar of Sales, we come up with 1.12 (or 112%). This means Microsoft has more working capital than its sales last year; if you remember from the lesson, manufacturers of heavy machinery require the most working capital and range from 20-25%. The 112% figure is excessive by anyone's standard. The main concern should not be financial safety, but efficiency. Why isn't Microsoft putting this money to work? Current Ratio The current ratio should be at least 1.5 but probably not over 3 or 4. Taking Microsoft's current assets and dividing them by the current liabilities, we find the software company has a current ratio of 3.56. Unless the business is saving resources to launch new products, build new production facilities, pay down debt, or pay a dividend to shareholders, a current ratio this high usually signals that management is not using cash very efficiently. Quick Ratio To calculate the quick ratio, we have to take the quick assets and divide them by current liabilities. If you've studied Microsoft's current assets, you will notice there is no entry for inventory. You know that Microsoft sells software; meaning its products consist of information It doesn't need to carry inventory. As soon as a customer places an order, the company can load its program onto a CD-ROM or DVD and ship it out the same day. Because there is no inventory, there is no risk of spoilage or obsolesce. Inventory is what causes the biggest difference between the current and quick ratio. The quick ratio was designed to measure the immediate resources of a company against its current liabilities. Almost all of Microsoft's resources are already liquid. The only things that aren't are the $1.949 billion in deferred income taxes (how are you going to use it to raise cash?) and the $2.417 billion attributed to "other" current assets. Subtract these from the $39,637 billion in current assets and you get $35.271 billion. This $35 billion in quick assets represents the things the company can turn in to cash almost immediately. Divide it by the current liabilities ($35.271 divided by $11,132) and you get 3.168. Even under the most stringent test of financial strength, Microsoft has $3.168 in current assets for every $1 in liabilities. Inventory Turn & Average Age of Inventory We already discovered that Microsoft carries no inventory. It is absolutely efficient. Its products are already sold before they are manufactured. Receivable Turn and Age of Receivables You'll notice that on the income statement excerpt, credit sales is not listed as a separate item. Instead, we have to use the less accurate total sales or revenue figure to calculate receivable turn. Take the $25.296 billion in revenues and divide it by the average receivables, $3.4605 billion ($3250 + 3671 divided by 2). You will end up with 7.30 turns. To calculate the number of days this translate into, take 365 divided by 7.3. In Microsoft's case, the answer is 50 days.* Debt to Equity Ratio Microsoft is debt free. It has no long or short term debt. If you take $0 (the amount of the company's debt) and divide it by the shareholder equity ($47.289 billion) you will get 0. This means that 0% of the company's equity consists of debt; the shareholders own it all. Final Thoughts All of our calculations have shown one thing; the company has virtually no risk of bankruptcy. Microsoft has 3x the cash it needs to survive, no long term debt, no inventory to worry about, and extremely strong current and quick ratios. Its working capital per dollar of sales is 112%, excessive by any standard (especially compared to its competitors. Adobe Software had a ratio of 36%, while Oracle Systems came in at 46.5%). The main question an investor should ask when looking at the balance sheet is, "why so much cash?". None of the company's top management has given any clues as to the plans for the growing pile of greenbacks. *You should generally calculate turns for the past several years, as well as between quarters. The numbers will almost always fluctuate during the normal course of business; regardless, a superior company will tend to have superior ratios over the long term. Simon Transportation Services Now that we've looked at an outstanding balance sheet, let's look at one that signals the company may be running into trouble. Simon Transportation is a trucking company that specializes in temperature- controlled transportation for major corporations such as Anheuser Busch, Campbell's Soup, Coors, Kraft, M&M Mars, Nestle, Pillsbury, and Wal-Mart. If you look closely, you will start to see problems develop in 2000 that foretell of future financial difficulties. Simon Transportation Services, Inc. Consolidated Balance Sheet - September 30, 2001 Assets Current Assets Sep 30, 2001 Sep 30, 2000 Cash and Cash Equivalents N/A $3,331,119 Short Term Investments N/A N/A Receivables $36,495,339 $34,265,075 Inventories $1,302,067 $1,330,462 Prepaid expenses and other $2,528,675 $2,325,199 Total Current Assets $40,326,081 $41,251,855 Long Term Assets Long Term Investments N/A N/A Property, Plant and Equipment $83,795,541 $49,403,534 Goodwill N/A N/A Intangible Assets N/A N/A Accumulated Depreciation (or N/A N/A Amortization) Other Assets $5,574,182 $451,603 Deferred Long Term Asset Charges N/A N/A Total Assets $129,695,804 $91,106,992 Liabilities Current Liabilities Accounts Payable $46,031,588 $21,844,631 Short Term Debt $74,537,820 $3,437,120 Other Current Liabilities N/A N/A Total Current Liabilities $120,569,408 $25,281,751 Long-Term Liabilities Long Term Debt $835,000,000 $16,376,791 Other Liabilities N/A N/A Deferred Long Term Liability Charges N/A $4,604,318 Minority Interest N/A N/A Total Liabilities $120,569,408 $46,262,860 Shareholder's Equity Misc. Stock Option Warrants N/A N/A Redeemable Preferred N/A N/A Preferred Stock $5,195,434 N/A Common Stock $62,917 $62,877 Retained Earnings ($50,503,733) ($2,451,176) Treasury Stock ($1,053,147) ($1,053,147) Capital Surplus $51,865,007 $48,285,578 Other Stockholder Equity $3,559,918 N/A Total Stock Holder Equity $9,126,396 $44,844,132 Income Statement Total Revenue $278,818,242 $231,396,894 Cost of Revenue $253,268,462 $163,611,569 Simon Transportation Services Simon Transportation Services filed for Chapter 11 bankruptcy in the early part of 2002. The company's balance sheet showed signs of strain almost two years prior. We are going to focus most of our attention on the 2000 part of the balance sheet to demonstrate that an intelligent investor could have seen warning signs before the company went under. Note: Since we are going to be focusing on 2000's numbers, we will not average in 2001's numbers to calculate inventory and receivable turn. Cash Position Simon had $3,331,119 in cash in September of 2000. It also had $3,437,120 in short term loans. This is the first sign the company was using borrowed money to operate. Almost all of the company's current assets are tied up in receivables, which is a real concern that customers may not be paying on time. Working Capital In 2000, the company had working capital of $15,970,104. Working Capital per Dollar of Sales In 2000, the company had total sales / revenues of $231,396,894. With working capital of $15,970,104, the company had a total Working Capital per Dollar of Sales percentage of 6.9%. Simon operates in the trucking industry, so most of its assets are fixed (in the form of diesels, trucks, semis, etc.) Current Ratio The current ratio should be at least 1.5 but probably not over 3 or 4. Simon had a current ratio of 1.631 in 2000. This is mediocre. The quick ratio will be a much better indication of the company's financial health. Quick Ratio The company's quick assets come out to around 1.487. Inventory Turn & Average Age of Inventory The company's inventory turn for 2000 only is 122.97 (meaning the company clears its inventory around every 3 days). In most situations, this would mean the company would have smaller working capital needs. However, if you look at the current assets, you notice they consist almost entirely of accounts receivable. Although the business sells its inventory frequently, it isn't converting those sales into cash immediately. Thus, the receivable turn is going to be very important to the success of this business. Receivable Turn and Age of Receivables Credit Sales are not carried individually. Thus, we will have to use the total sales / revenues of $231,396,894 with receivables of $34,265,075 in 2000. The receivable turn comes out to 6.75 times per year, or once every 54 days. So, although the company is clearing its inventory every 3 days, it is only getting paid every 54 days. Since the inventory turns aren't being converted to cash, the business needs more working capital. The 6% of working capital per dollar of sales we calculated earlier is dangerously low. Debt to Equity Ratio Combine Simon's short and long term debt, and you'll come up with $19,813,911. Divide the $44,844,132 in shareholder equity by this amount and you'll see that 44.18% of the company's equity is made up of debt. This would be acceptable if Simon enjoyed high enough return on equity to justify such a high borrowing level. A glance at the company's income statement shows that this is not the case; Simon lost money in 2000. Not only is the company not making money, it is losing money altogether. Common sense tells you that a business that is heavily in debt and is losing money probably isn't financially secure. A quick look into the company's 10k and 10q statements reveals that the short term loans are secured by the receivables. In plain English, if Simon Transportation fails to pay its short term loans on time, the bank can go to court and take control of the receivables. If this were to happen, the business may not have enough cash on hand to pay its long term debt, which makes up a sizable part of the balance sheet. If Simon ran into a bump in the road, it probably wouldn't be able to survive because of cash flow issues. Final Thoughts Here's what we've observed: In 2000, a full year before declaring bankruptcy, Simon Transportation had very little working capital, barely acceptable current and quick ratios, a high percentage of debt to equity, and inventory that was quickly sold but slowly collected for. The company may be able to survive as long as it doesn't run into any problems. An increase in fuel prices, a driver strike, or some other unfavorable event that increased losses would quicken the company's financial demise. An item of particular concern is found in the company's 10k, "The Company's top 5, 10, and 25 customers accounted for 24%, 39%, and 57% of revenue, respectively, during fiscal 2000. No single customer accounted for more than 10% of revenue during the fiscal year." According to these numbers, each of the top five customers accounted for nearly 5% of Simon's business. If just one of these switched to another trucking company, five percent of the business' revenues would have been lost. If the company had profitable with little or no debt, this would not be a concern. When you're counting on things going smoothly and you're playing with money that's not your own, you're almost always headed for disaster. The bottom line: This is not a company you would invest in if you were looking for something long term and considerably safe. Epilogue On December 14, 2000, Simon issued a press release. It had run into a bump in the road. Here's an excerpt: "In addition to the change in accounting method, during the quarter, Simon experienced the highest driver turnover in its history. Turnover exacerbated recruiting costs and contributed to increased claims and repair expense, and low tractor utilization. In addition, high fuel prices continued to affect the truckload industry, including Simon." To correct this problem, Simon's management increased driver pay by 2¢ per mile, an increased cost the company could hardly afford. Perhaps most disturbing of all, the company openly acknowledged in its 10k around the same time that it was in violation of its long term debt agreements. "The Company's secured line of credit agreement contains various restrictive covenants including a minimum tangible net worth requirement and a fixed charge coverage covenant. As of September 30, 2000, the Company was in violation of the minimum tangible net worth requirement. The Company obtained a waiver of the violation and as discussed in Note 10 has amended the covenant subsequent to September 30, 2000." In February of 2002, the company filed for Chapter 11 bankruptcy protection. Had an investor been able to analyze a balance sheet, they would have been warned in advance of the company's problems and possibly avoided huge losses to their portfolio.