Companies often have a great ‘story’ that attracts me to them for their upside potential. However, if things don’t turn out as expected my capital is at risk if the company has a weak balance sheet.

Balance sheet weakness means a firm isn’t built on solid financial foundations, so it makes sense to check the strength of the balance sheet before anything else and reject shares that don’t measure up. How should I do that?

Three-step check

One answer came to me in a neat, time-efficient package delivered by well-respected financial blogger and investor Paul Scott when I read one of his Small Cap Value Reports over on Stockopedia. Paul occasionally posts on The Motley Fool bulletin boards under the pseudonym Paulypilot and used to be a company financial director. Paul’s approach is to look at a firm’s balance sheet and follow this three-step check:

1) Look for a positive net tangible asset value (NTAV)

Using AIM tiddler Robinson (LSE: RBN) as an example, we can click on the preliminary results report and scroll down to the balance sheet, which it labels as Statement of Financial Position. To find the net asset value we first locate the line labelled Net Assets, hown with a value of £24.557m.

To strip that down to tangible net assets we take off the intangibles. Scroll back up to the top of the balance sheet and locate Goodwill at £1.264m and Other Intangible Assets at £6.655m. Now take both those figures from the net asset figure to arrive at an NTAV of £16.638m.

That’s a positive figure as required by the test as the firm has more in property, plant, equipment and other ‘real’ assets than it carries in borrowings and other liabilities.

Robinson makes packaging for fast-moving consumer goods and this is a good test for such a trading company. However, other firms in other sectors can run asset-light businesses and some intangible assets can be valuable. So it pays to judge each case individually and sometimes it’s worth loosening this test and looking for a positive Net Asset Value that includes intangibles instead.

2) Work out the current ratio and ensure it’s ideally at least 1.2  

A firm’s current ratio (AKA the working capital ratio) gives an indication of its ability to meet short-term debt obligations. A reading of one or above is good but the higher the better. Paul aims for at least 1.2.

To work out the current ratio, divide Current Assets by Current Liabilities. From Robinson’s balance sheet, Current Assets come to £15.645m and Current Liabilities to £14.159m. The Current Ratio works out at 1.1. Not 1.2, but close.

3) Make sure net debt and pension deficit is acceptable   

Under Current Liabilities, Robinson’s balance sheet shows Borrowings of £4.461m. Under Non-Current Liabilities, the borrowings figure is £1.132m. Adding these together, the gross borrowings figure is £5.593m.

To get the net debt figure, take off the cash the firm shows it holds on the balance sheet. Cash is listed under Current Assets at £4.688m, so the net debt is £0.905m. Is that acceptable? I like to compare debt figures to a company’s earnings to help me judge. Scrolling up to Robinsons’ Group Income Statement, I see the firm posted an Operating Profit Before Exceptional Items of £2.407m — over twice the firm’s net debt figure.

However, I like to be even more conservative and use gross debt rather than net debt figures rather as cash has a habit of disappearing without much notice but debts hang around for much longer! Gross debt stands at about 2.32 times the firm’s operating profit, which is acceptable.

Happily, Robinson declares Pension Assets of £3.747m and no pension liabilities, so I’ll ignore the pension arrangements for the time being.

I decided not to invest in Robinson recently, but the firm got through the three-step check and I rejected it for other reasons.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.