How To Go Through a Balance Sheet?

Before any investor invests in a company's stock you need to understand how to read and interpret that company's balance sheet. It is most important for all classic value investors who look to purchase company 's shares for less than its tangible assets. Understanding the balance sheet helps investors avoid investing in bad companies. However, the balance sheet alone won't prevent any investors from investing in another Enron. We'll just focus on the basics of how to go through the balance sheet to find diamonds in the rough.

For Value investors, the balance sheet is were it all begins and ends.

Old school classic value investors focus on the balance sheet where they can value a business's assets to its current market price after deducting for debt. I'll use a company with a clean balance sheet like Friedman Industries.

Friedman (FRD) has a simple and clean balance with no off the books liabilities. The statements are easy to read and understand. Making the company a great example on how to read and understand a company's balance sheet.



Cash and Marketable Securities

Companies with lots of cash tend to have a strong balance sheet with little to no debt. If a company's net cash per share exceeds market value then the company is a potential Graham net net investment.

Friedman has $2.2 million in cash and no marketable securities. The company had $15 million in cash in 2013. However, the company spent a large amount of their cash on its operations and share buybacks.

Accounts Receivable

Accounts Receivable is an indication of whether a company is able to collect payments. If accounts receivable decrease from the previous years, that is a sign that the company is collecting payments. However, you should go back a few years in order to determine if accounts receivable have spikes or drops.

Friedman's saw their accounts receivable decline to $6.9 million in 2014 from $9.3 million. When you look at 10 years of Friedman's balance sheet, you see that accounts receivable have been declining every year and average $5.9 million over the last ten years.

Inventory

Inventory is one of the most important parts of the balance sheet. Benjamin Graham wrote numerous times that inventory should be marked down by 50% for liquidation value. You should also compare inventory to the cost of goods sold. If the difference is large enough, this is a good indicator to investors that a manufacturer or retailer will stumble.

Friedman has $40 million in inventory which turns over 2.5x a years. This isn't good, however, the steel sector is currently depressed due to low demand and cheap steel from China.

One Time Items

Deferred income tax and income tax receivables shouldn't be counted as part of a company's assets. Investors need to keep an eye on this since management has a habit of deferred income tax or income tax receivables to inflate earnings.

Friedman doesn't have deferred income tax or income tax receivables, which is a good thing since these two items add no value to the company or shareholders.

Property, Plant and Equipment (PP&E) and Goodwill

PP&E is very important when a company is going to liquidation. These are non-liquid assets owned by the company.  If the company owns land or buildings, more research needs to be done to value those assets. Also, current GAAP accounting rules value land and real estate at cost in the balance sheet. This creates opportunities to unlock value by reappraising real estate and land to reflect the value of those assets.

Goodwill are intangibles that arise when a business purchases another business or the brand of the company like Coca-Cola. It is best that you place no value on Goodwill.

Friedman has $15 million in PP&E and zero goodwill on its balance sheet. They own a 90,000 square foot warehouse, two facilities in Arkansas and Alabama and are in the process of building a third facility in Texas. Buildings and improvements are valued at $7 million on Friedman's balance sheet.

Liabilities

The liabilities section is similar to the asset section of the balance sheet. These are debts and other payments that the company has to pay in full or pay interest on.  Keep an eye out for companies with large debt loads.

Friedman Industries has no long-term debts and $1.1 million in pension liabilities. Pension liabilities have to be looked at with a close eye since company management have a habit of under funding their employee's pensions. Friedman is reasonable and upfront about its pensions. The possibility of changes in Friedman's pension liabilities eating up the company's earnings is highly unlikely.  The company has no of the books liabilities and its books are pretty clean and reflect how the company operates.

Quality Of Assets

As you go through a company's balance sheet, you should ask yourself what makes up the company assets. Does the company owns its buildings, land, and other assets in full? How much could the company receive in a liquidation for their assets, property, plant, equipment, and other? This helps you gauge the quality of the company's asset which produce its earnings.

What is the quality of Friedman Industries? I believe that the company has valuable assets. The company owns its warehouses, two facilities and is building a third one. Friedman produces steel coils and steel tubes and runs a wholesale operation for their products. Currently the steel sector globally is depressed due to the lack of demand and prices from China. This has hurt Friedman and forced the company to produce their products at a higher cost and sell at a lower price. However, Friedman has been around for nearly 80 years and has survived numerous bearish steel markets. The steel market will come back as it always does. When its does, Friedman will see their earnings rise in addition to free cash flow.

Summing It Up

Published on Nov 4, 2015
By Cody Eustice
Cody is a freelance writer who has been writing financial articles for various sites for over a year now. He is a value investor looking for companies that sell for far less than their estimated business value.

Copyrighted 2016. Content published with author's permission.

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