Four ways to test balance-sheet strength

In these uncertain times, investors keep being told to look for strong balance sheets before buying a stock. But what does a strong balance sheet look like? Here are four things to watch out for.

1. Low debt

In a bull market, debt can be very useful. Say you take £20 of your own money and £80 borrowed from a bank to buy an asset worth £100. It doubles in value to £200. You could sell it, repay the £80 and pocket £120. So you have multiplied your opening stake of £20 six times.

But in a recession the downside becomes apparent. Suppose that a £100 asset falls to £50. You still owe the bank £80. Sell the asset and you'll wipe out your £20 of equity and still owe £30. So firms with high net borrowing to equity 'gearing' are vulnerable if loans are called in. They're also unlikely to be able to afford to buy cheap assets in a slump. So while some sectors, such as utilities (where firms have substantial assets and good cash flows), can stomach high debt, as a rule of thumb, low gearing is best.

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2. Control over working capital

Retailers such as supermarkets are lucky they are paid by customers well before they have to pay suppliers. But in other sectors a survival skill is managing stocks, debtors ('receivables') and creditors ('payables'). Buy too much stock, give customers too long to pay, or pay suppliers too soon, and even a profitable business can run out of cash.

So check the length of the 'working capital cycle'. Say a firm's average stock level (opening + closing stock from the balance sheet divided by two) is £50m and the cost of sales £350m. That means the stock cycle is 52 days (50/350 x 365). If the average owed by debtors is £40m and turnover is £500m, then debtor days are 29 (40/500 x 365). Lastly, if the average owed to creditors is £75m, then creditor days are 78 (75/350 x 365).

So on average it takes the firm 52 days to turn stock into sales, 29 days to collect cash from customers who used credit and 78 days before suppliers are paid for stock. Thus the average length of the working capital cycle is just three days, ie 52 + 29 78. That's the gap between cash leaving the business to pay for stock, and being received from customers. Three is very short in an aerospace business, for example, it could be much higher (100 days or more), but still be fine.

The trick is to benchmark firms against their sector, then watch for sudden changes. If the working capital cycle gets longer perhaps because unsold stock levels are rising, or customers are taking longer to pay, a balance sheet can quickly weaken.

3. Low impairments

In the good times, acquisitive firms snap up rivals using cheap debt to finance deals. Whenever a premium over and above net assets is paid for a rival, an asset called 'goodwill' appears on the predator's balance sheet. For example, if a firm pays £200m for a rival, using £100m in cash and £100m in new loans, and the target has net assets worth £140m, then goodwill is £60m (£200m £140m). This represents a payment for intangible assets, such as the target's reputation, market share, or key staff.

Here's the rub. A firm with lots of goodwill on its balance sheet has usually been very acquisitive. Purchases made during a bull run often turn out to have been expensive once the market weakens. RBS found this out to its cost, having paid an eye-popping £63bn for ABN Amro. The result is asset write-downs, or 'impairments'. When these are large or recurring, they are another sign of future balance-sheet weakness. A 'goodwill and other intangible fixed assets note' will tell you all about them.

4. Few hidden surprises

Failed firms, such as energy giant Enron, are often brought down by what's hidden off the balance sheet. The problem arises because accounting rules do not require firms to record all of their risks on the face of the balance sheet. Uncertain obligations perhaps to settle litigation claims can be described in a 'contingent liabilities' note instead. Also, relationships with 'connected' parties loans to directors, for example may not be clear from reading the balance sheet, but show up in a 'related party transaction' note.

Finally, major spending the board may have authorised, but not committed funds to as yet, often shows up in a short 'capital commitments' note. So it's worth flicking to the back of the accounts to see what's in these notes to ensure the firm isn't at risk from big hidden liabilities.