GWII Investment Framework: BMPB, Business, Management, Price vs. Valuation, and Balance Sheet,
GWII BMPB – Balance Sheet
When you analyze a company’s balance sheet you may think, step one – check the debt level, step two – consider if that debt level is acceptable, and step three – done. To conclude your analysis at this point oversimplifies the work and increases the probability that you have missed something. So as an analyst what should you be looking for? Aim to find a balance sheet that provides you with confidence especially when the economic environment becomes challenging.
How do you get confidence in a balance sheet? Start by partnering with a management team that is not taking unnecessary risk with the balance sheet. The most significant risk for any company is the risk of going out of business. One way to dramatically reduce the probability of going out of business is to not over-lever the balance sheet, this does seem obvious, however, sometimes it’s been missed. The management should be doing some basic asset-liability matching. An example of potentially taking too much risk is significantly levering up the balance sheet to do an acquisition, avoid these situations. Another practice that should at least give you pause is when a management team issues net debt to pay dividends. This is a potentially damaging practice, it serves current shareholders interests at the expense of the company’s long term prosperity – this is not sustainable.
Further, the balance sheet is one indicator of the financial discipline of management – an interconnection with the BMPB framework. Having net cash on the balance sheet is a good thing, don’t over optimize. As an analyst you want to understand how management thinks about the use of leverage. Review and analyze how management navigated periods of economic stress, e.g., the financial crisis in 2008-2009, covid-19 2020-2021. Did they raise cash when they could – prior to the stress period, or when they had to – during the stress period? This pandemic is an example of how things can happen outside of our control, we cannot predict the specific events, we can however, prepare – this is also from our management analysis. Did the management team prepare the balance sheet for difficult times. Difficult times will arrive at one point or another, our management teams need to have the business and balance sheet ready.
Metrics to use to evaluate the balance sheet: Interest Coverage Ratio / Time Interest Earned (EBIT/Interest Expense), Debt to Equity, Quick Ratio (cash and cash equivalents + marketable securities + accounts receivable/current liabilities). We’ll review more about metrics another time.
Your analysis should include the consistency of the company’s cash flow. For example, matching a cyclical business with a highly leveraged balance sheet can be a design for failure. Contrast that example with the consistent cash flow of a consumer staples company, example, Procter & Gamble (PG), its cash flow tends to be fairly consistent across economic cycles, therefore having some debt on the balance sheet is much more tolerated in times of economic stress. This is basic asset – liability matching.
If the company does have debt, put in the work to understand the company’s credit rating and the structure of the debt. Is the company’s credit rating: investment grade, high yield, or not rated? When is the debt due? All at once? Over time? What’s the interest rate? Is it fixed rate? Is it floating rate? What are the covenants? Understanding a company’s credit rating and the structure of its debt will provide you with a better view of the company’s overall risk profile.
To better understand the balance sheet will require more time and attention, we’ll continue in a future post, stay tuned. Our GWII Investment Framework series will continue and our next post will be a summary of the GWII Investment Framework: BMPB.
Rodney E. Lake
March 29, 2021
