I am a strong believer that an understanding of a company’s capital structure is as important as cash flow or earnings. The composition of the balance sheet can provide insight into whether a company is financially sound or on thin ice. It can also be a useful measure of the management team’s ability to generate (or destroy) wealth for shareholders. But perhaps most important, it should give valuable clues as to what type of business it is. One should be able to examine only the balance sheet and be able to determine in what industry the company competes.

Ok, so we know the balance sheet is important. Many value investors want to understand a company’s net asset value – which provides a good baseline for downside risk in a potential investment. How much total assets a company has on the books relative to debt or the entire liabilities. There are many different variations to this approach and all have some value if used properly. Companies with a heavy weighting of assets to liabilities may indeed be good value candidates. When calculating the net asset amount, take it a step further. The composition of current or liquid assets relative to total assets is a very important metric to understand. This also comes into play when using book value to price the assets. Ideally, we would like to see a greater weighting on current assets relative to total assets. A benchmark I tend to use is current assets should represent over 50% of the total. There isn’t anything magical about this amount. It’s just a basic guideline.

Consider the following two examples and let’s do a quick comparison of the balance sheets;

Mocon, Inc (MOCO)

2009	2008	2007	2006	2005
Cash and Short Term Investments	13.76	11.64	12.24	12.26	8.94
Total Receivables, Net	4.68	4.77	4.48	4.55	4.36
Total Inventory	4.27	4.73	3.97	3.62	4.06
Prepaid Expenses	0.58	0.85	0.34	0.25	0.31
Other Current Assets, Total	0.41	0.36	0.29	0.34	0.58
Total Current Assets	23.71	22.36	21.31	21.02	18.26
Property/Plant/Equipment, Total - Net	1.66	1.83	1.58	1.56	1.55
Goodwill, Net	3.3	3.27	3.1	3.1	2.64
Intangibles, Net	0.74	0.66	0.57	0.63	0.87
Long Term Investments	0.57	4.47	2.79	0.38	0.17
Note Receivable - Long Term	0.0	0.0	0.0	0.0	0.0
Other Long Term Assets, Total	0.36	0.38	0.33	0.2	0.17
Other Assets, Total	0.0	0.0	0.0	0.0	0.0
Total Assets	30.33	32.95	29.67	26.88	23.66

LHC Group, Inc (LHCG)

	2009	2008	2007	2006	2005
Assets
Cash and Short Term Investments	0.39	3.51	1.16	28.05	17.4
Total Receivables, Net	78.69	66.28	73.24	55.95	45.45
Total Inventory	0.0	0.0	0.0	0.0	0.0
Prepaid Expenses	11.93	6.46	5.66	4.12	3.71
Other Current Assets, Total	4.37	4.96	2.95	1.94	0.15
Total Current Assets	95.38	81.21	83.0	90.05	66.72
Property/Plant/Equipment, Total - Net	21.36	16.35	12.52	11.71	10.22
Goodwill, Net	139.47	112.57	62.23	39.68	26.1
Intangibles, Net	46.85	29.98	14.06	8.26	0.0
Long Term Investments	0.0	0.0	0.0	0.0	0.0
Note Receivable - Long Term	0.0	0.0	0.0	0.0	0.0
Other Long Term Assets, Total	3.17	3.3	3.18	3.0	1.58
Other Assets, Total	0.0	0.0	0.0	0.0	0.0
Total Assets	306.23	243.4	174.99	152.69	104.62

We see that Mocon’s current asset composition is 78.2% while LHC Group’s is at 31.1%. This doesn’t necessarily mean that one is more valuable than the other – but it does provide clues about each business. We quickly gather that while LHCG has grown much more rapidly, it has done so by acquisition – notice the growth in the goodwill entry. Approximately 47% of MOCO’s total asset base is cash alone, while LHCG’s cash position is negligible. When I’m valuing a business on asset value, I prefer to see it predominantly in convertible things such as cash, receivables, and inventories as opposed to intangibles or fixed assets.

To be clear, this doesn’t necessarily mean that MOCO is a better investment, it simply means that its asset value is more reliable. Remember – not all assets are equal.

What Worked in the Stock Market for Long-Term Investors?

Extensive research has found that the companies with predictable revenues and earnings outperform the market average; they also suffer lower probability of loss. As a matter of fact, this kind of companies are exactly what Warren Buffett wants to buy and hold forever. Please read the research about what worked in the stock market:

Part I: What worked in the market from 1998-2008? Part I: Predictability Rank
Part II: Role of Valuations
Part III: Intrinsic Value, Discounted Cash Flow and Margin of Safety

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