Chapter 45: Balance Sheet Analysis

The previous discussion centered on the situation in which the balance sheet apparently justified a higher price than prevailed in the market. The more usual purpose of balance sheet analysis is to detect the presence of financial weakness that may detract from the investment or speculative merits of an issue. Careful buyers of securities scrutinize the balance sheet to see if the cash is adequate, if the current assets bear a suitable ratio to current liabilities, and if there is any indebtedness of near maturity that may threaten to develop into a refinancing problem.

·         Working Capital Position: Previously a working capital ratio of $2 current assets for $1 of current liabilities was regarded as standard for industrial companies. The investor must form his own opinion as to what is needed in any particular case.

·         Large Bank Debt Frequently a Sign of Weakness: Financial difficulties are almost always heralded by the presence of bank loans or of other debt due in a short time. In other words, it is rare for a weak financial position to be created solely by ordinary trade accounts payable. This does not mean that bank debt is a bad sign in itself – the use of reasonable amount of bank credit particularly for seasonal needs is desirable. But, whenever the statement shows Notes or Bills Payable, the analyst will perform closer scrutiny.

§  When a company’s earnings are substantial, it rarely becomes insolvent because of bank loans.

·         The Danger of Early Maturing Funded Debt: A large bond issue coming due in a short time constitutes a critical financial problem when operating results are unfavorable. Investors and speculators should both give serious thought to such a situation when revealed by a balance sheet. Maturing funded debt is a frequent cause of insolvency. Even when the maturing debt can probably be taken care of in some way, the possible cost of the refinancing must be taken into account.

Comparison of Balance Sheets Over a Period of Time: This important part of security analysis may be considered under three aspects:

1.    As a check on the reported earnings per share.

Comparing the total earnings for a company over a 10 year period as reported by the income statement with the change in shareholder equity on the balance sheet over this period provides a check on the reliability of the earnings reported. This would show if any charge offs have been made directly to the balance sheet without going through the income statement, thus overstating the reported earnings.

Increase in shareholder equity = Total 10 year earnings – Total 10 year Dividends paid

2.    To determine the effect of losses (or profits) on the financial position of the company.

Sometimes while taking losses the company may actually improve its financial position and likewise even when showing profits the company could have a deteriorating financial position.

Losses that are represented solely by a decline in the inventory account are not so serious as those which must be financed by an increase in current liabilities. If the shrinkage in the inventory exceeds the losses, so that there is an actual increase in cash or reduction in payables, the company’s financial position has been strengthened even though it has been suffering losses.

If we have large earnings but a coincident deterioration of the financial position due to heavy expenditure on plant and a dangerous expansion of inventory.

3.    To trace the relationship between the company’s resources and it’s earning power over a long period (30 years). This comes into play only in an exhaustive study of a company’s record and inherent characteristics.

Graham uses the example of US Steel and Corn Products Refining Company to illustrate the long range study of earning power and resources. He uses the balance sheet at the beginning and end of each decade over a 30 year period. He calculates the return on average capital for each decade [(Avg Earnings)/(Avg Capital)].

Capital = Fixed and misc assets + Net Working Capital;

Avg Capital = (Capital at Beginning of decade + Capital at End of decade)/2

 

Operating Results
Item	1903-1912	1913-1922	1923-1932	Total for 30 years
Finished goods produced	93.4 tons	123.3	118.7	335.4
Gross Sales	$4,583	$9,200	$9,185	$22,968
Net Earnings	979	1674	1096	3749
Bond Interest	303	301	184	788
Common Dividends	140	356	609	1105

 

Relation of Earnings to Average Capital
Item	1903-1912	1913-1922	1923-1932	Total for 30 years
Capital at beginning	987	1416	2072	987
Capital at end	1416	2072	2112	2112
Average Capital	1200	1750	2100	1700
% earned on average capital per year	8.1%	9.6%	5.2%	7.4%
Average common equity	237	620	1389	816
% earned on common equity	17.7	18.3	4.8	9.0
Depreciation per year	24	34	46	35
Average fixed property account	1000	1320	1600	1300
Ratio of depreciation to fixed property	2.4%	2.6%	2.9%	2.7%

 

Balance Sheet Changes
	Dec 31 1902	Dec 31 1912	Changes in 1st decade	Dec 31 1922	Changes in 2nd decade	Dec 31 1932	Changes in 3rd decade	Changes in 30 years
Assets: Fixed and Misc	820	1160	+340	1466	+306	1741	+275	+921
Net Current Assets	167	256	+89	606	+350	371	-235	+204
Total	987	1416	+429	2072	+656	2112	+40	+1125
Liabilities: Bonds	380	680	+300	571	-109	116	-455	-264
Preferred stocks	510	360	-150	360		360		-150
Common stock	508	508		508		952	+444	+444
Surplus/Reserves	411 (d)	132 (d)	+279	633	+765	679	+46	+1090
Total	987	1416	+429	2072	+656	2112	+40	+1125

 

US Steel has earned a satisfactory 8% return on capital in the first two decades but it earned only 5.2% in the third decade. The actual investment in US Steel was more than doubled and its productive capacity was increased threefold. Yet the average annual production was only 27% higher, and average annual earnings before interest charges were only 12% higher in 1923-32 than 1903-12. This raises the question if steel production has been transformed from a reasonably prosperous into a relatively unprofitable industry and if this transformation is due in good part to excessive reinvestment of earnings in additional plan, thus creating over capacity with resultant reduction in margin of profit.

A similar analysis of Corn Products shows that it was able to increase its earning power proportionately with its enlarged capital investment. It earned 5.0%, 11.8%, 10.7% in each of the three decades. Its annual profits (both before and after depreciation) were about four times as large in this decade as in the period ending in 1915. Thus the record of Corn Products Company does not suggest the same questions or doubts as arise from US Steel.