Sometimes the most basic principles can be the ones that are most easily overlooked. When investing in small caps, balance sheet strength is not only important for companies to remain a going concern, but it is also imperative in ensuring that these companies can grow and deliver a return on shareholder’s capital. For some investors, the balance sheet can become a box ticking exercise, and you can see why; it’s not quite as exciting as double-digit earnings growth, a huge addressable market, or a store rollout, but it can become very exciting (in a bad way) when things go pear shaped.

The balance sheet is one thing that investors should never ignore, and it becomes particularly important in cyclical downturns when earnings are challenged. Recently, we have seen headwinds across several industries including consumer discretionary, building materials, and (rather severely) in agriculture. Over this time there has been a common theme: capital intensive, cyclical businesses raising money following their share prices falling to pay down their debt (that they previously thought could be paid down with earnings).

This exercise can dilute existing shareholders and makes it more difficult for companies to earn an adequate return on capital – especially when the cost of equity is significantly higher than debt.

Some recent examples are Nufarm Limited (ASX: NUF), Bega Cheese Limited (ASX: BGA), Wagners Holding Company Limited (ASX: WGN) and Costa Group Holdings Limited (ASX: CGC).

Source: Bloomberg

Looking out towards 2020 investors can learn from these events to ensure they don’t ignore the balance sheet for companies facing earnings headwinds – especially for companies with high fixed costs and large capital requirements. Buying a beaten-up stock when everything is going wrong can, in the right circumstances, be a winning strategy for generating returns, however, ensuring the balance sheet is strong is crucial to help protect returns. 

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This wire is part of the 'One thing investors can't ignore in 2020' series. To download the full ebook please click here

Pasan Perera

Hi Rachel, recent finance graduate here, want to know if there is a technique we can use to see how accounts receivable gets converted to cash and matching it up with the receipts from the cashflow statement.

Rachel Cole

Hi Pasan, When analysing a company one of the first questions for us is how well a business converts earnings to cash flow – which is an indicator of the quality of the accounting earnings. The metric used will depend on the type of business, but a common one is the GOCF/EBITDA where GOCF (Gross Operating Cash Flow) is receipts from customers less payments to suppliers. Changes in working capital will be the key difference between the two items in the above metric so you do have to look at receivables to understand the differences. When assessing the accounts receivable we would tend to look at receivables turnover and days sales outstanding, as comparing those metrics from period to period can help in understanding the movements in the cash as well. I hope this helps!