QUALIPORT
Signs Of A Strong Balance Sheet

By Maynard Paton (TMFMayn)
March 29, 2004

Financial commentators often refer to balance sheets as being 'strong' or 'weak'. But like most stock market terms, the definitions cannot cater for all company situations. Indeed, what may seem a fragile balance sheet may actually support a solid business. On the other hand, many a troubled firm has reported a sizeable amount of net assets.

In this article reviewing the basics of a balance sheet, the assets and liabilities of Gallaher (LSE: GLH) were highlighted. At the end of 2003 the tobacco group had net liabilities of £276m -- a seemingly precarious financial position, especially as net debt totalled £2.4b. However, Gallaher has continued to churn out good profit and dividend growth over the years and is a member of the Qualiport's watch list. So what gives?

The first point to consider when evaluating a balance sheet (or for that matter, any part of the accounts) is the company's activity. In Gallaher's case, manufacturing and selling cigarettes enjoys steady, predictable demand, has substantial barriers to entry and is not at the whim of a handful of customers. Cash flow is therefore very reliable.

In addition, Gallaher's key assets -- brand names, brand loyalty and other intangibles -- are not shown in the balance sheet. Yet these intangibles have a significant value in reality, since they are the major props to the company's cash generation. It's fair to say the bookkeepers fail to appreciate Gallaher's true balance sheet value.

With these factors in mind, banks remain happy lending money to Gallaher. They are aware of the company's reliable cash flow and can see beyond the asset valuations stated in the balance sheet. Although operating with large debts, Gallaher's interest cover ratio puts the borrowing situation into perspective. During 2003, interest payments were covered a reasonable five times by operating profits.

Gallaher's £276m net deficit is therefore nothing for shareholders to worry about. In fact, Gallaher could claim to have a 'strong' balance sheet: heavy-duty tangible assets are not required to operate successfully while generous amounts of debt are used to finance expansion, thus allowing shareholder earnings to fund greater dividends.

Broke with assets

In contrast to Gallaher's asset-poor-but-great-company status, these two former private investor favourites provide interesting asset-rich-but-bad-company examples:

SFI                                                    May 31	2002       (£m)	2001       (£m)
Fixed assets	226.2	187.7
Current assets	26.1	16.3
Short-term creditors	(31.6)	(16.0)
Net current (liabilities)/assets	(5.6)	0.3
Total assets less current liabilities	220.1	188.1
Long-term creditors	(120.4)	(102.7)
Provisions	(14.7)	(10.9)
Net assets	85.5	74.4

Independent Insurance                December 31	2000       (£m)	1999       (£m)
Investments	282.0	349.4
Reinsurer's share of technical provisions	463.1	127.2
Debtors	721.6	503.9
Prepayments and accrued income	193.6	127.8
Other assets	57.6	49.3
Technical provisions	(1,161.9)	(725.0)
Creditors	(221.6)	(100.4)
Other liabilities	(18.1)	(22.4)
Net assets	316.3	309.8

SFI and Independent continually reported plenty of assets, yet they still came unstuck. Both companies had identifiable problems with their cash flow (this article and this article have more) and eventually found they could not meet their liabilities. Though reporting millions in assets, the balance sheets eventually proved to be critically weak. The assets could not generate the necessary cash and provided no support as the shares became worthless.

Money mountain

Sadly, not all businesses have the ultra cash flow reliability of Gallaher. But there is one bookkeeping feature that can prove almost as attractive: a mountain of surplus cash.

It's standard practice for companies to report their net cash/debt position in every interim and preliminary set of results. There are caveats with this figure (such as seasonal trading and deferred income), but cash-rich businesses rarely threaten investors with a total loss.

Among the Qualiport watch list shares, the following stand out as carrying excess cash:

Company	Market value (£m)	Annual earnings (£m)	Net cash (£m)	Net asset value (£m)
DFS Furniture (LSE: DFS)	460	38	32	67
London Stock Exchange (LSE: LSE)	1,045	62	222	352
Renishaw (LSE: RSW)	365	14	29	107
Rotork (LSE: ROR)	337	20	32	77

The balance sheets of these four shares would traditionally court the adjective 'strong'. Beware, though, that a large cash pile is not always indicative of dependable cash-generative assets held elsewhere in the company. Clearly, surplus cash alone will not stop competitors or industry conditions adversely affecting profits and cash flow in the future.

Probably a better term for the four balance sheets would be 'supportive'. If trouble strikes, the associated cash piles will almost certainly carry the above companies through. Businesses sensitive to an inherently unpredictable economy, such as engineers Renishaw and Rotork and retailer DFS, are quite wise to keep cash on hand in time of emergency.

Summary

Going on the Gallaher, SFI and Independent Insurance examples, there's more to 'strong' and 'weak' balance sheets than just net asset value. What's important is liquidity: firms hit trouble not because of a lack of assets, but because of a lack of cash produced by the assets and held in the bank.

Where next? The Basics Of A Balance Sheet | Balance Sheet Tricks And Treats | Useless Financial Ratios | Qualiport Guide To Debt

The author owns shares in DFS Furniture and London Stock Exchange.