The balance sheet is one of the most important financial statements for a company and its investors and yet it’s one of the financial statements that’s often most overlooked.
The balance sheet looks at the financial health of a firm at a single point in time. This means it’s open for manipulation, as a company can delay paying suppliers until a week after the balance sheet date (thus artificially inflating cash on the balance sheet), but in the end these tricks all come out in the wash.
Being aware of what to look for can save you a lot of money when investing.
Check the quality of assets
Not all assets are created equal. By checking for the quality of the assets you can dig deeper into what’s really on the balance sheet. Most private investors won’t go into this level of detail — so by doing what most private investors don’t do you can gain an edge.
Always look at current assets first. These are assets that can be readily deployed, or liquid assets such as cash and inventory. We want to know that the business has enough firepower in its current assets so that it can pay current liabilities and meet its working capital requirements.
We also want to check for the quality of the assets. It’s no good a restaurant operator owning plenty of freehold sites where it has units if those units are beginning to look shabby and deteriorating aesthetically. Clearly, there’s going to be a lot of necessary maintenance capex needed to be spent on those assets and they may not be worth what they’re said to be worth on the balance sheet. Remember, management has discretion on the depreciation and amortisation of these assets — so be careful!
Tangibles and intangibles
Another good check for the quality of assets is to check the tangible and intangible assets. One ratio investors like to use is NAV (Net Asset Value) — but what if 80% of a company’s NAV is made up of intangible assets?
Now, I’m sure we can all agree that The Coca-Cola Company can say that the value of its star brand is worth mega-millions. It’s a timeless brand known the world over. But let’s say a newly minted plc is saying that the value of its brand is in the millions, yet it’s only seeing a few hundred thousand pounds in revenue and haemorrhaging cash through losses. Can we really say the same? Just make sure that the balance sheet isn’t propped up by poor quality assets or riddled with intangibles.
A good way to do this is to use NTAV (Net Tangible Asset Value).
By using NTAV we get rid of intangible assets and only take into account what’s there and what’s real. This is an effective and conservative way of checking what a company is really worth and how strong the company’s balance sheet is.
Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.