Five danger signs on the balance sheet

In these troubled times, monitoring balance sheets is more important than ever for investors. So what are the warning signs you should watch out for?

"The job of a professional investor is as much about avoiding disasters as it is about picking winners," says Anthony Bolton, Fidelity's ex-fund management star, in the FT. Stocks to avoid have three things in common: "poor balance sheets, poor business models, and poor management". And in the current climate, monitoring balance sheets is more important than ever.

The balance sheet is a snapshot, taken at a single point in time at the end of a financial year. It gives a rough idea of the value of a business by presenting all of the assets deployed, less all of the obligations outstanding (such as loans, overdrafts and supplier balances) and showing how the net result "net assets" has been financed by shareholders ("shareholders' funds"). It all balances because the net asset position and the total contribution from shareholders must be equal. So what are the warning signs to watch out for?

Balance sheets: beware a debt mountain

Just as many individuals supplement a modest deposit with a large mortgage to buy a home, so companies borrow from banks, or issue IOUs called bonds, rather than relying solely on shareholders for capital. High debt relative to the company's overall net worth, or even relative to a firm's cash flows, can be a disaster, says Bolton, especially if, as is likely in the current tough economic climate, profits start falling and interest costs begin to rise.

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When trying to work out how much debt the company has, the key is to make sure you have hunted down all potential liabilities. Pension fund deficits, preference shares (which pay a fixed dividend, ahead of any other, and often have a set redemption date too, just like a bond), plus what accountants call "contingent liabilities", all count. To find these you will need to hunt around towards the back of the accounts and digest the "contingent liabilities" note, which may reveal potential future obligations, including (as yet) unresolved lawsuits and customer claims.

Balance sheets: check the dates

Another trick when reviewing debt levels is to check the date the balance sheet was prepared. The trap with a seasonal business, such as a retailer where sales and cash receipts rise and fall sharply during the year, is to assume that the debt recorded on a single day at the year-end is typical. The result can be a "false impression of strength". One quick test is to divide the interest expense in the profit and loss account into year-end debt and multiply by 100. If the resulting percentage is a lot higher than the firm's disclosed funding costs, the year-end debt figure may understate the true size of borrowings.

Balance sheets: look for the cash

A healthy cash balance not only reduces your vulnerability should the worst happen losing your job, for example it also gives you great bargaining power as prices fall. It's the same for companies. Check the "cash in hand and at the bank", plus any short-term investments in the "current assets" section of the balance sheet. Also check the net debt note (which records interest-bearing debt minus cash). Low cash balances and high net debt are warning signs.

Balance sheets: growth often comes at a price

As Bolton notes, you need to invest in growing companies to make decent returns. But often you find that the faster firms grow, the harder they fall. Companies pursuing helter-skelter growth tend to burn through cash at a frightening rate often because they are spending extravagant amounts on new assets, overpaying to buy up rivals or simply offering overly generous payment terms to win new customers.

Fast growth, Enron-style, can leave cash inflows struggling to keep pace with cash commitments. So watch out for balance sheets that are growing rapidly the overall "net assets" figure is a reasonable benchmark particularly if cash balances are being hammered and net debt is rising fast.

Bringing it all together: Z scores

The Z-score offers a shorthand way of finding out how robust an organisation is. Devised by Dr Edward Altman of New York University in the mid-1960s as a bankruptcy-prediction model, this blends crucial balance-sheet ratios into a single score. Any company with a weak Z score (typically anything much below two for a public company) is in the danger zone. The calculation can be done from scratch, or by using a pre-prepared spreadsheet.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.