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Three Overlooked Balance Sheet Items

May 12, 2011 | About:
Alex Morris

Alex Morris

36 followers
The first lines of the 18th chapter of Security Analysis (5th edition) read, “The balance sheet deserves more attention than Wall Street has been willing to accord it for many years.” In an investment space dominated by earnings estimates and a media that only cares about one ratio (the P/E), this statement is as true today as it has ever been. This article will be a discussion on three aspects of balance sheet analysis (meaning the accounts and notes about them found in the financial statements) that are often overlooked or disregarded by individual investors: pension funding, debt covenants, and different methods of accounting for expenses.

PENSION ASSETS & LIABILITIES

For starters, analysts must realize that pension assets and liabilities are not consolidated in the balance sheet as presented by the company (outlined in detail in the footnotes, where the assumptions must be checked to make sure they are not aggressive or overly optimistic). However, they are still visible to some extent: SFAS 158, adopted in September 2006, requires companies to include the difference between the fund assets and the projected benefit obligation, and report that figure as an asset (if overfunded) or a liability (if underfunded). For example, PepsiCo (PEP), which has an underfunded pension, groups the amount in an account entitled “Other Liabilities” on the balance sheet. Simply looking at this figure as cash or debt is not suggested: “Because of the lack of ready access to these cash items, we do not believe that it would be helpful to include them with the company’s other cash.”

DEBT COVENANTS

Another figure that might be misleading is the debt account due to bank loans, which might require the company to maintain “compensating balances” or certain ratios as part of the agreement; this might not require adjustment in the analyst’s analysis, but should be noted when digging through the SEC filings and considered (a mistake I’ve previously made with Callaway Golf (ELY), which was forced to issue highly dilutive preferred shares in June 2009 due to poor capital management and nearly failing to comply with debt covenants). The same concern was part of the reason (among other issues like the CFO leaving) why Dean Foods (DF) saw their stock price plummet last year when they were in danger of violating their debt agreements.

CAPITALIZING VS. EXPENSING

Certain items, like leases, can be capitalized (become an asset for the company) as they are incurred, or they can be expensed (as an operating expense within one operating cycle). For leases, the Financial Accounting Standards Board (FASB) has ruled that a lease should be treated as an capital lease if it meets any one of the following four conditions –

(a) If the lease life exceeds 75% of the life of the asset, or

(b) If there is a transfer of ownership to the lessee at the end of the lease term, or

(c) If there is an option to purchase the asset at a "bargain price" at the end of the lease term, or

(d) If the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.

However, as noted in Security Analysis, “The accounting rules to distinguish between capital and operating leases use arbitrary criteria… it is quite simple to convert a capital lease into an operating lease by structuring the terms appropriately.” For this reason, it is important to first off note which methodology is used, and secondly how it affects the financial statements.

Here is how Aswath Damodaran, a finance professor at NYU who has invaluable investing and accounting resources on his website, differentiates between the two: “In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases.”

As he says, the balance sheet affect from a capital lease is that it increases the asset and liability accounts; naturally, this will have an effect on comparable ratios, so the analyst should make sure to account for these differences when comparing measures like ROA or fixed asset turnover. As always, the most important thing is to understand what is being described through the ratios (and the accounts), not necessarily just the quantity/value of each; without adjusting for the inherent subjectivity in financial statements, investors will be lost in a sea of numbers that are for all intensive purposes useless. Understanding the pension plan, debt covenants, and expense methodologies effect on the balance sheet should help the investor on the path towards meaningful analysis.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

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