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In this lesson, we are going to turn our attention to the Balance Sheet, also known as the Statement of Financial Position...
under International Accounting Standards.
The Balance Sheet shows us what we own and what we owe as at a specific moment in time.
Let’s return to the Home Depot and look at the Balance Sheet to see what stories we can uncover here.
One of the first places to start, is to see whether the company has any cash.
If it doesn’t, it likely has bank indebtedness shown under the current liability section below.
Some companies like Microsoft and Apple have huge stores of cash on the Balance Sheet.
May others have none at all.
For those with little or no cash, the concern is liquidity, that is having sufficient cash to pay bills as they come due.
And what are the bills we need be concerned with?
Well obviously employees and suppliers are top of mind,
but you can’t forget to consider the funded debt obligations- these are the ones that can really get you in trouble if you miss a payment.
In fact, the biggest risk for many companies is refinancing large debt balances on maturity or upon breach of lending covenant.
So, you’ve got to read the financial statements carefully to see whether or not this is a concern.
Liquidity is discussed specifically in the MD&A. Let's take a look.
And here you find your liquidity and capital resources discussion.
If we return to the Balance Sheet, we should still be able to piece together the liquidity story without having to refer to the MD&A.
To begin with, let’s look at a simple Current Ratio, that is current assets divided by current liabilities.
The way to interpret a Current Ratio is that if it is less than one, that might be an indication of a looming liquidity issue, but not always.
For instance, cash based businesses, like hotels and restaurants, have limited inventory and receivables;
and consequently a seemingly weak Current Ratio.
But generally speaking we like to see current ratio well above 1:1 and ideally closer to 2:1.
A variation of the Current Ratio is the Quick Ratio, and it is calculated the same way,
only excluding inventory [and prepaids] from current assets as inventory is typically harder to liquidate on short notice.
Again, the result just gives us one more indication of liquidity strength.
Next, we should look at our debt maturity profile.
Current portion of debt repayments often shows as a current liability already,
but you can also refer to the Notes of the Financial Statements to understand when major debt arrangement mature.
This is particularly troublesome in recent years as refinancing existing debt has not easy to achieve in many businesses.
Now that we have a sense of the short term liquidity position, let’s look more broadly at liquidity in a long term context.
Financial leverage occurs when the company use other people’s money, in the form of debt instruments, to finance its business.
My boss was always fond of the expression: Debt is like a double edged sword and equity is like a soft pillow, and
when you want to sleep at night, you better off to rather sleep with a pillow than a sword.
What this means is that when times are good and sales are rising,
using other people’s money can be very profitable increasing your Return on Equity, as we discussed in previous lessons.
However, when sales soften, having debt can quickly overwhelm you if you aren’t able to sustain payments, or
meet the financial covenants.
Having lots of equity in the company on the other hand, is far more conservative from a liquidity standpoint.
Your shareholders can’t put you out of business the same way a bank can.
So what’s the right answer?
Well, there is a lot of theoretical justification for having some level of debt in the finance structure.
Using debt lowers the overall cost of capital which makes the company more competitive.
For example, a company with the lowest cost of capital is able to acquire strategic targets more readily.
than a company with a higher cost of capital.
The trick is finding the right amount of debt, which can be described notionally as:
An amount that balances the desire to minimize the cost of capital with the financial risk associated with default.
To complicate matters, every business is different.
For instance, utilities are regulated businesses that generate a very stable return.
In the interest of minimizing cost of capital, and hence electrics that citizen pay,
regulators require that these utility companies carry debt in the range of 50 to 70% of their total balance sheet.
At the other extreme end of the spectrum, a commodity based mining company may not use any debt...
given the high cyclicality of the industry and the volatility of the underlying commodity prices.
Let’s look at a couple of ratio to help us uncover the debt leverage story.
First, we have the Capitalization Ratio.
This ratio is calculated as the funded debt divided by capital employed.
Funded debt is a combination of short and long term debt that has formal terms associated with it.
Capital employed is your funded debt plus your shareholders’ equity.
A ratio of 75% or higher would be considered high.
40-60% is common for your large, mature, well- established companies.
All others types of companies typically would have capitalization ratios less than 40%.
A similar ratio is the Debt to Equity Ratio.
This ratio is calculated by dividing total liabilities by total equity.
It would rare to see a healthy company with a ratio more than 3:1.
and a more comfortable ratio for many companies is more in the 1:1 range.
This ratio is often referenced by banks in the financial covenants.
And finally, a common leverage ratio used by investment banks to determine the amount and availability of a lending facilit is...
the Funded Debt to EBITDA Ratio.
Generally speaking, secured lenders will make debt financing available based on a multiple of the company’s EBITDA.
The upper end of such a facility is around 2 times EBITDA.
This too is a common ratio that gets including in lending agreements and is used to calculate the amount of availability under the lending facility.
Now that we have a sense as to how much debt we should have on the Balance Sheet,
we need to evaluate how well the company is able to service that debt.
The two ratios that are common here are Times Interest Earned and Debt Service Coverage Ratio.
Times Interest Earned is calculated as your earnings before interest and taxes divided by interest expense.
Monitoring this ratio can help to identify when a company is nearing a point of financial distress.
Generally speaking, an Interest Coverage Ratio of less than 1.5 is considered dangerous.
A healthy ratio would be five times or higher for a strong, stable, cash flow positive company.
Debt Service Coverage is a similar ratio, however in the denominator we also include principal repayments.
So there you have it. A pretty comprehensive look at this issue of evaluating liquidity and financial leverage.
But we aren’t finished looking at the Balance Sheet just yet.
As we move down below current assets, you will find capital assets.
Tangible Capital Assets are your property, plant, and equipment.
These types of assets can be financed with debt instruments, at least in part.
Below that you may find Intangible Assets.
An Intangible Asset may be something like a patent, a trademark, a customer list, a brand.
Or it may be goodwill.
Goodwill is only recorded if the company has acquired a company for more than the fair value of the assets identified during the acquisition.
Internally generated goodwill is never recorded on the Balance Sheet.
The importance of taking notice of Intangible Assets, is that these sorts of assets cannot be financed with anything other than equity.
Many analysts will take the value of Intangible Assets and immediately subtract it from the Book Value of Equity.
The logic for doing this is that Intangible Assets are not liquid.
They only remain assets in an accounting sense so long as the company is able to continue...
generating excess cash flows to substantiate their value.
It’s very common to see companies writing down intangible assets after a bad year or when they have just completed an acquisition.
Let’s move down to the liabilities section.
Accounts payable is an important and free source of financing.
The same way our customers do whatever they can to delay paying us,
we should be thinking the same thing and we can calculate and compare or Days Payable Outstanding.
Of course you can only do so to the extent that it does not hurt the relationship with the supplier
There are lots of different types of liabilities, some are monetary, others estimates.
Estimates include: warranties, accruals, environmental clean up committments.
The timing and amount of some of these estimates is subject to considerable judgement.
Also you need to look out for any mezzanine sorts of financing.
Mezzanine financing is a layer of financing between senior debt and equity.
Senior debt is secured lending.
Mezzanine financing is normally unsecured lending.
Not only is the coupon interest rate higher on mezzanine financing,
very often there are equity features to consider as well, such as:
Equity conversion rights, or
Detachable warrants
These instruments will be factored into your Diluted EPS calculations that we saw on the Income Statement.
Bbut for any other analysis, you’ll have to go back into the Notes to the Financial Statements to learn about the terms of these instruments.
Notice that the Home Depot does not appear to have an mezzanine types of financing.
Finally, you should aware that not all liabilities get recorded on the balance sheet
There may be contingencies, commitments, guarantees, and leases to consider.
Again, this information is in the Notes to the Financial Statements.
The residual left over, after we have looked at the assets and removed off the liabilities, is the shareholders’ equity.
Often there will be a separate statement that details the activities that happened in the shareholders' equity during the year.
The accounting can get a little crazy for some of these capital transaction.
But in short, net income increases your retained earnings.
Dividends reduces your retained earnings.
Other comprehensive income exists largely to record holding gains and losses...
associated with Balance Sheet items...
that have yet to be recognized through the Income Statement.
Stuff like hedging gains/losses, investment holding gain/losses, foreign subsidiary translation gains/losses.
These only get recognized through income once the instrument is unwound, sold, or impaired.
Common shares and paid in capital will fluctuate from activities such as:
New share issuance
Private placements
New issues
Exercising of stock options
These accounts will decrease from repurchases of company shares through open market transactions...
or other company initiated bids.
At the end of the day, it really is the net amount of shareholders' equity which is the most important.
Once again, in the same way that the dollar amount of net earnings had limited meaning,
the same could be said about the dollar amount of equity.
What is more relevant is knowing how much of the equity balance is attributable to each share.
From disclosures on this statement, you can see there are 1.7 billion shares outstanding at of the year end date- January 30th,
and we can convert the equity balance into a Net Book Value per Share number.
Again, you can subtract the Intangible Assets to get a Tangible Net Book Value Per Share,
which you can interpret as a value of the share if the company had to be liquidated today
We’ll see this metric again when we perform investment analysis.
So there you have it, the Balance Sheet story
Home Depot has a strong balance sheet, a fairly conservative financing structure, and adequate liquidity.
Until next time,
Don’t stop until you get to the top and when you get to the top, don’t stop!