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.

“Now more than ever having a strong balance sheet is imperative” – Paul Taylor, Fidelity International

So with coronavirus and the threat of recession challenging balance sheets around the world, I reached out to four leading fund managers to get their view on the most important elements to focus on when assessing the strength of a company’s balance sheet. Responses come from Paul Taylor, Fidelity International; Chris Stott, 1851 Capital; Joe Magyer, Lakehouse Capital; and Victor Gomes, Eiger Capital.

3 areas that point to financial strength

Paul Taylor, Fidelity International

For an investor, at any point in time, you want to have a strong understanding of a balance sheet, and now more than ever having a strong balance sheet is imperative. A company may have wonderful prospects but if it does not have the balance sheet to support its operations it may never get to realise those prospects.

I would argue that it is important to examine the whole balance sheet - problems can sprout from all different areas. For instance, financial instruments and hedging can be put in place by management to lower risk and secure their future, but I have seen a number of companies blown up by poor hedging strategies. Contingent liabilities can seem to come out of nowhere to threaten a firm’s existence, as can old school pension liabilities, excessive employee benefit build-ups, prepayments and product warranties.

Having said all this, to assess balance sheet strength and potential vulnerability the three areas I focus on are:

1. Net cash / debt
2. Gross debt duration and diversity; and
3. Working capital requirements and capital ratio

Net cash / debt is the difference between the total debt and the total cash of the company. Obviously the less net debt the better and in fact having a net cash position is the ideal situation in this environment. Companies that have been severely impacted by Covid-19 might now be burning cash every month. In this environment I want to make sure companies have enough net cash to cover to any scenario of cash burn to get to the ‘other side’ of Covid-19.

Gross debt duration and diversity is also important in limiting balance sheet vulnerability. During the GFC many companies were caught out having all their debt in one bank and maturing at the same time. I want to make sure a company has their debt diversified across different financial institutions as well as public markets. I also want to ensure there is limited debt maturing in the next 12 months and in fact spread out over multiple years. This ensures the company does not get caught out having to repay large amounts of debt all at once.

Working capital requirements should also be monitored closely. Some companies have negative working capital models where they receive the cash before they need to spend any money on producing the product or service. A company with a negative working capital model is obviously in a very strong position to survive through most environments. If, however, a company needs to invest a lot in inventories well in advance of receiving cash themselves this will mean their working capital will significantly drain their cash flow and make them vulnerable to any debtor problems or other cash flow strains. The current ratio is an important measurement here to assess the likelihood of vulnerability.

All three of these balance sheet issues point to a company’s financial strength and how long it can survive in a difficult economic or market environment.

The most important factors we consider

Chris Stott, 1851 Capital

Assessing balance sheets is a critical part of any investment process, in particular in times of heightened volatility and market uncertainty. The three most important factors we look at when assessing the strength of a company’s balance sheet are:

1. Debt levels: there can be stigma attached to holding high levels of debt, however it can be a positive if a company has strong cash flows to service their debt through the cycle. Historically, some of the biggest returns coming out of a bear market are investments in highly leveraged companies. One example is apparel business Pacific Brands during the GFC. In March 2009, the company was carrying almost $1 billion of company debt and was priced to go broke at $0.14 a share. However, the company had a track record of generating strong cash flows and, as conditions improved, and the market had gained comfort in the company’s prospects to survive. Its share price climbed to $1.19 over the next four months. Assessing a company’s debt providers is also important. In the case of corporate debt, it is always insightful to see which lenders are backing a company, and which ones have elected not to. Its common in the small-cap space to see businesses dealing with alternate lenders at different stages of the cycle which can be a red flag. In the case of automotive and selected property businesses, look through gearing (debt both on and off the balance sheet) is also important in understanding where the company’s exposures lie. In the current climate, it appears the banks will continue to support their existing corporates who are under financial stress.
2. Net Tangible Assets (NTA): assessing a company’s NTA provides an important snapshot of a business’s assets. Companies that have been highly acquisitive never screen well on this measure as they typically have high levels of intangible assets on their balance sheet. It is always useful to assess how often the levels of goodwill are tested by the company and the assumptions used. We expect that the upcoming reporting season in August will see increased write downs of goodwill and other intangibles given the current state of the economy. Finally, it can be prudent for companies that have most of their NTA in working capital to assess the age of the inventory, along with average debtor and creditor days.
3. Working capital: debtor, creditor and inventory levels are fundamental in analysing and reconciling a company’s cash flow and form the most important part of any company analysis in our view. Over recent months, the rapidly changing operating environment many companies working capital has been squeezed quickly. Of particular note, travel companies have been greatly impacted due to widespread travel bans. Another more recent example is home appliance business Breville which raised $104 million of new equity. The key purpose of the capital raising was to fund working capital requirements due to expected pressure in coming months.

Don’t build your house on sand

Joe Magyer, Lakehouse Capital

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.

The paradox of balance sheet strength

Victor Gomes, Eiger Capital

The great paradox of balance sheet strength is that businesses which have it, often don’t need it, whereas businesses that need it, often can’t get it.

Obviously, the strongest balance sheets are those with little or no net debt. Better still, net cash. Think here Apple Inc (US$40b net cash) or in Australia, Technology One (A$84m net cash). Businesses such as these with high ROIC (Return On Invested Capital) and low capital needs can fund growth from internal sources without resorting to external debt. Conversely, businesses with low ROIC and high capital intensity are often those with the weakest balance sheets. Their returns on capital are insufficient to generate the free capital required to adequately fund their operations, hence the need to supplement with debt or new equity capital.

In assessing the balance sheet strength of any company, we like to focus on four key areas:

1. Serviceability. Often expressed via leverage ratios such as net debt/EBITDA or net debt/equity. The former is the more commonly used ratio although investors should always assess this ratio in the context of qualitative business factors such as revenue defensiveness, cyclicality and levels of recurring revenue. The more defensive and recurring a company’s revenues, the higher the leverage ratio it can usually sustain and vice versa. As a rule of thumb, a net debt/EBITDA ratio of less than 1.5x implies lower balance sheet risk. A ratio of between 1.5-2.5x suggests some risk so be alert to funding crunches if circumstances change. Lastly a ratio of greater than 2.5x indicates higher balance sheet risk such that debt levels should ideally be reduced. Some companies may point to undrawn debt facilities as evidence of balance sheet strength. Be wary of this factor as a sign of balance sheet strength given, as we saw during the GFC, lenders can quickly pull such lines leaving companies in the lurch at the exact wrong point in cycle.
2. Stability. This factor refers to the stability of the debt burden which can be impacted by foreign currency movements or changes in interest rate margins. Borrowing money denominated in a different currency to that of the operating business is highly risky. Large unfavourable movements in exchange rates can cause debt to blowout. A credit downgrading can also result in a material increase in the margin charged by lenders. Look for evidence of hedging both FX and interest rate which can mitigate these risks.
3. Covenants and Tenor. Lenders will place certain conditions on the debt (known as debt covenants). For example, prescribed maximum debt/EBITDA ratios or debt/market capitalisation caps. A breach of a covenant can trigger default requiring either early repayment, an increased interest margin levied or force a dilutive equity raising to correct the breach. Each outcome will cause financial stress, sometimes resulting in permanent shareholder value destruction. A company’s ability to service a debt repayment schedule is also important to assess (tenor of debt). Obviously, longer dated repayment schedules and manageable debt amortisation rates will entail lower risk than short term borrowings and large bullet repayments.
4. Hard Asset Coverage. This factor attempts to assess the level of real or hard assets coverage for the debt (excluding intangible assets). Lenders will often feel more comfortable lending to businesses that have substantial hard assets as opposed to those with high levels of unidentifiable intangibles (for example, large goodwill acquired via a rollup strategy). For the same reason that it is cheaper and easier to borrow via a mortgage than an unsecured loan, a business with hard assets will provide lenders with more comfort during difficult times.

Putting the theory in action

In part two of this series, our four contributors share eight companies facing headwinds, but with balance sheets that are built to survive. Hit the “FOLLOW” button below to be notified when I post the wire.

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