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Stepan Lavrouk
Stepan Lavrouk
Articles (74) 

4 Uses of the Balance Sheet

Guru Bruce Greenwald on applying Grahamite analysis to balance sheets

February 06, 2019 | About:

Columbia professor Bruce Greenwald is a well-known scholar of value investing, having spoken at GuruFocus’ own Value Conference in 2018. He has been referred to as a "guru to Wall Street’s gurus" and has written several books on the subject of value investing. One particularly interesting work of his is a short introductory essay to Graham and Dodd’s "Security Analysis" on the topic of balance sheets. In it, the professor outlined what he sees as four fundamental areas of usefulness of the balance sheet.

On resources

“First, the balance sheet identifies the quantity and nature of resources tied up in a business. For an economically viable enterprise, these resources are the basis of its returns. In a competitive environment, a firm without resources cannot generally expect to earn any significant profits. If an enterprise is not economically viable, then the balance sheet can be used to identify the resources that can be recovered in liquidation and how much cash the resources might return.”

The advice here is two-fold. First, use the balance sheet to determine whether a business is capable of surviving in a competitive environment. This is of particular importance in a capital-intensive industry, for example, carmaking. An automobile company that does not invest into maintaining its plants will obviously soon fall behind the curve.

Second, businesses selling below their book value, although rare nowadays, can still be found. In these cases, buying a business priced below its liquidation value can provide a margin of safety -- even if the business does not recover, the principal sum invested should be safe.

On stability of future income

“Second, the resources on a balance sheet provide a basis for analyzing the nature and stability of sources of income. As Graham and Dodd note: 'There are indeed certain presumptions in favor of purchases far below asset value and against those made at a high premium above it … A business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely' ... they recognize that earnings on assets that are well in excess of a company’s cost of capital will be sustainable only under special circumstances. Thus, earnings estimates will be more realistic and accurate if they are supported by appropriate asset values. Earnings without such support are likely to be of short duration and, thus, of less value than earnings protected by the necessary returns on assets in place."

All good things must come to an end. A company cannot, in most cases, over a long period of time enjoy extremely high returns on capital without attracting some level of competition. Therefore, the balance sheet provides an important check for investors to make sure that a company with extremely high earnings has an asset base that can support those earnings going forward.

On liabilities

“Third, the liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm. A high level of short-term debt (or long-term debt that expires in the near future) indicates a possibility of debilitating financial distress. Under these circumstances, even a slight impairment in profits may lead to a significant permanent loss in the value of the business.”

This point is fairly straightforward -- the balance sheet is the place to go to ascertain what a company’s debt load is. Oftentimes so-called "growth stories" are fueled with significant amounts of obligations, which can become a serious problem if the growth company fails to transition to becoming cash flow positive.

On the quality of earnings

“Fourth, the evolution of the balance sheet over time provides a check on the quality of earnings ... A balance sheet is a snapshot of a company’s assets and liabilities at a particular time. It can be checked for accuracy and value at that moment. This places significant constraints on the degree to which the assets and liabilities can be manipulated. In contrast, flow variables such as revenue and earnings measure changes over time that by their nature are evanescent. If they are to be monitored, they must be monitored over an extended period."

Earnings are notorious for being easily manipulated, a point we have explored in the past. A balance sheet, on the other hand, is a relatively static measure of what a company is made up of. As such, it is significantly harder to fudge without committing outright fraud, something most finance departments are wary of doing, even if they are willing to skirt the grey areas of accounting conventions to juice their earnings a little bit.

Summary

There are obviously myriad different ways a diligent investor can use the balance sheet that go beyond these four areas. But in general this is a good checklist for what to look for in an investment, as well as for red flags to avoid. Always remember to pay attention to all parts of a company's financial disclosures, rather than just the income statement.

Disclosure: the author owns no stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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