As investors, we tend to obsess over company profits. The size of profits and whether they meet expectations can move share prices and affect how much money, if any, will be paid out in dividends.
During the financial reporting season profits tend to dominate headlines but seasoned investors are more likely to turn to a company’s balance sheet as a better gauge of financial health. The balance sheet is the part of a firm’s financial statement that provides a snapshot of its assets, liabilities and equity.
Used properly, the data can tell investors how much debt a company has, whether there is too much unsold stock and if customers are paying on time; or at the other end of the spectrum, whether a company is investing its surplus cash wisely or, perhaps, allowing too much to sit idle.
Hollywood studio Metro-Goldwyn-Mayer filed for Chapter 11 bankruptcy protection in 2010, five years after a consortium that included Japanese electronics giant Sony took over the company using a form of financial engineering called a leveraged buyout.
That takeover would eventually leave MGM, linked to films such as The Wizard of Oz and Gone with the Wind, labouring under an unsustainable debt burden of about $4bn (£2.4bn).
Although the studio is still making films – having emerged from bankruptcy under the ownership of its former creditors – the sorry affair serves as a cautionary tale highlighting the potential pitfalls associated with excessive debt.
Too much debt scares us. As investors, we feel much safer when a company offers evidence of a strong balance sheet, which usually means it has spare cash available to fund corporate expansion or boost shareholder returns via share buybacks and/or to raise dividend payouts.
How surplus cash is spent can also say a lot about a company. Alarm bells should start ringing when property developers invest in professional football clubs (as some do in China), or when companies buy exotic financial instruments they barely understand (remember the synthetic collateralised debt obligation?).
Having said all this, management teams have a lot of discretion in the way they present financial numbers because these statements are the sum of many assumptions.
An “ambitious” treatment of assets can help inflate a balance sheet. Valuing so-called intangible assets – goodwill, intellectual property or brands – can be a subjective exercise, while placing an accurate value on biological assets, such as palm oil and timber, can also be difficult.
Financial officers also have a degree of discretion in the way they treat research and development, either expensing it (incurring a cost) or capitalising it (adding to the balance sheet).
Companies may borrow money by selling hybrid securities that combine attributes of both debt and equity. Instruments such as perpetual bonds allow companies to raise debt and yet, for accounting purposes, they show up as equity on the balance sheet.
Corporate pension obligations can be managed by changing certain assumptions on discount rates; short-term debt can be arranged around key financial dates to dress up a company’s debt profile; and analysts often need to be alert for debt incurred that may not be reflected fully on a holding company’s balance sheet.
Keep it simple
So what is the solution? Our preference is always for simple businesses because they are easier to understand. If the accounts are too complicated or the ownership structure unclear, we would rather not be shareholders.
Hong Kong-listed Café de Coral is a great example of a company that we like very much. You cannot get much simpler than a consistently profitable chain of fast-food restaurants. It is one of Hong Kong’s most recognisable brands for cheap and cheerful Chinese food and has expanded across the border into other parts of southern China.
But more than that, growth has been financed almost wholly from cashflow so Café de Coral boasts a healthy balance sheet with minimum debt.
Just like a backbone, a balance sheet can tell you a lot about the character of a company.
Hugh Young is managing director of Aberdeen Asset Management Asia