The key elements of a rock-solid balance sheet

The following article appeared on Livewire on May 28, 2020

In a bull market, investors focus on the income statement. But in a bear market, balance sheets come to the fore. Get both elements right and you’ve got the ingredients for a great investment. But untangling the information in these statements can be a challenge for even experienced investors.

So with coronavirus and the threat of recession challenging balance sheets around the world, Joe provides examples of what to focus on when assessing the strength of a company’s balance sheet.

Don’t build your house on sand

It is crucial to consider the balance sheet in the context of the company’s profitability and economic model. A bank might have high gearing in absolute terms but far less than peers, for example, better enabling it to navigate a downturn. Meanwhile, companies for whom paradigm shifts create more of a risk and opportunity (e.g. IT) should run with ample cash and little debt. Also, a profitable business with strong recurring revenue can afford to carry a degree of leverage, while a cashed-up business that is burning cash might not be as robust as the balance sheet would suggest.

That said, absolute levels also matter. That same bank that might have a less aggressive balance sheet than its rivals but still has outsized exposure to liquidity risk in capital markets and vulnerable consumers and industries within a softening economy. For the better, once a cash position starts to swell, the strategic optionality increases exponentially. For example, while there are more than 600 ASX-listed companies with greater net cash relative to their market capitalisation versus Facebook, none could put US$5.9 billion behind a strategic investment like Jio Platforms and still have more than US$40 billion left over.

Don’t forget about the sources of debt either. A business reliant on a single credit facility might be a house built on sand relative to another funded by a wide pool of creditors with debts maturing far into the future. The latter point rarely matters when credit markets are liquid, however, when the opposite is true it is almost the only thing that matters.

Disclosure: Joe Magyer and the Lakehouse Global Growth Fund own shares of Facebook.