Hey Friends,
There’s no real risk assessment without balance sheet analysis. My book, “Choose Stocks Wisely,” presents two quality checks to aid in analyzing the health of the balance sheet. These checks are the Adjusted Current Ratio (ACR) and the Adjusted Tangible Stockholders’ Equity (ATSE).
Losses can and will occur with stock investing. The goal is for loss to be the exception rather than the rule. Also, a loss that one wants to completely avoid is that of default. That is, you may have to sell a stock from time to time where you receive less than you paid but one doesn’t want to experience a total loss, meaning owning shares in a business that goes bankrupt. One can always take funds received from selling shares in a limited loss situation and rebuild those funds into a strong gain by investing in a better situation. But when an investment is wiped out, there’s no recovery of those funds. It’s “start completely over.” It takes money to make money and an occasional limited loss doesn’t keep one from going in a forward direction with the portfolio but a default circumstance can devastate performance.
Companies that experience default often do so through cash-flow insolvency. The balance sheet may show solvency, that is, the assets exceed the liabilities. However, the assets are not liquid enough to pay off day-to-day bills as they come due. Companies may also default through balance sheet insolvency — meaning liabilities are greater than assets. Many companies today with a thriving stock price show balance sheet insolvency. But they are generating sufficient cash flow to pay bills on time, make interest payments on debt timely, and even pay dividends. Default happens when you can’t make that next required payment. If it’s an interest payment, the debt holders can petition for bankruptcy proceedings.
My ACR is to check the balance sheet for liquidity to see if there’s a solid ability at this moment to pay day to day bills as they are coming due. That is, the ACR looks for evidence of cash-flow solvency. My ATSE checks for evidence of solid balance sheet solvency. Together, these can help significantly in the assessment of default risk.
So, I continue harping on proper balance sheet analysis before putting money to work in equity investments because to ignore these checkups is to subject self to the one risk you don’t want to experience at all, namely default.
Have a good weekend.
Paul, I was wondering what your thoughts are on companies with consistently decreasing equity over the past several years. Even if the company is undervalued based on the current financial position, is it unwise to invest in these because the ATSE could be significantly lower in the next couple of years? I know earnings play a large part, but If equity is consistently decreasing by a large percentage every year, I would assume that means the company is mismanaging the finances. If the industry is good and the earnings are expected to improve, should I still be skeptical because they are reducing the equity that belongs to the stockholders? The reason I ask is because I see many companies with the same level of EPS and different levels of change in equity, so I was wondering if it was a poor stewardship concern?
Your question is more involved than I can do justice toward via commentary. Many large companies engage in stock buybacks, even resorting to borrowing to increase buybacks. This disrupts one’s analysis of equity norms (earnings increase equity and dividends decrease equity). Declining equity year after year can indeed signal poor financial management. But it could signal a product or service that is not really wanted by the consumer market. The best financial management won’t help a business that sells goods few people want. Or declining equity might be due to the nature of the business. If it’s a biotechnology company developing a drug and going through trials, there would be years of losses before any revenues come along “if” the drug makes it through trials and is approved by the FDA. For me, I’d prefer to see company profits translating into increasing equity. If a company is generating solid profit and cash flow but experiencing declining equity as any kind of pattern, it would be on my avoid list.