Security Analysis:Chapter 16

Now we will deal with balance sheet analysis.

For cash items, the analyst should include everything equivalent to cash; the analyst should include all the cash equivalents the company lists and any equivalent which is not shown as current but could be if the company decided to. Cash-surrender value of life-insurance policies are generally shown as an intermediate item, but the analyst may include them as part of current assets for the purpose of certain calculations, such as finding the current asset value of the stock.

For inventories, valuation is the most important factor, especially pertaining to the FIFO and LIFO methods, as discussed in Chapter 11.

Receivables should be shown as current assets, even if the period of repayment extends well over a year. Some companies sell the receivables to finance companies or banks under the condition that the company is responsible for nonpayment. These amounts should be added to both receivables and current liabilities.
When receivables play a large part of the company's business, extra attention is needed to make sure that the reserve for losses and collection expense is enough; comparisons should be made with other companies in the same field.
Some companies set up reserves for income tax to be paid upon collection of the receivables, but the analyst should subtract these directly from the receivables to make a more accurate figure.

Any reserves which represent a fairly definite liability should be considered by the analyst as current liabilities. Current liabilities should be all liabilities due within a year.

Intermediate assets include non-current receivables, investments not treated as marketable securities, cash-surrender value of life insurance, and deferred assets. Most companies include claims for tax refunds, but some show this as a current receivable.

Fixed assets, also known as the plant account and property account, is carried usually at actual cost minus depreciation.

Prepaid Expenses and Deferred Charges are sometimes confused. A prepaid expense is an expense paid in advance which has actual value, like paying 12 months of rent at the beginning of the year. Each month, this prepaid expense will be deducted by 1/12th. A deferred charge is very similar, but has no substance. For instance, 100 thousand dollars may be spent to start a company, but, instead of charging the full 100 thousand at once, it could be called a deferred charge, and amortized over a period of time.
Large prepaid expenses/deferred charges must be examined closely, but, usually prepaid expenses/deferred charges are too small to matter and can be ignored.

Bond discounts are when a company sells a bond and receives less than par value for them. The discount can be charged off against surplus or carried as an asset and be amortized over the life of the bond. Usually, these items are too small to matter much.

Intangible assets include good-will, patents, copyrights, trade-marks, franchises and licenses, organization and development expenses, etc.

Leaseholds - the right to occupy a premises for a stated period of time subject to payment of rent. It may be considered an asset if the rent is well below current-rental value of the property, but it is intangible.

LIABILITIES

The analyst is concerned with two main things when dealing with liabilities: the treatment of reserve items and the proper valuation of the preferred-stock liability. We have already gone over the treatment of reserves.

Preferred-stock liabilities - preferred-stock's main value is the right to a fixed dividend above the common shares, and is similar to a bond in that it is a fixed security. To value the preferred-stock liability, an analyst can follow this simple rule:
value preferred-stock at the highest of: par value (plus dividends), call price (plus dividends), or average market price. Sometimes, it might be more useful to create a par value, such as "the equivalent of a 5% dividend rate."

Most companies list preferred stock on the balance sheet at par value, but sometimes that is misleading.

Book value per share of common stock is arrived at by adding up all the assets (not including intangibles), subtracting all liabilities and stock issues ahead of the common, and then dividing by the number of shares. When calculating book value of preferred stock, do it in exactly the same way as you would common, but leave the junior issues out.

There are two other values that are important: current-asset value and cash-asset value.
Current assets consist of current assets alone minus all liabilities and claims ahead of the issue. (this excludes intangibles, miscellaneous, and the fixed assets).
Cash asset value consists of cash assets alone, minus all liabilities and claims ahead of the issue.
Free cash asset value assumes that the other assets of a company are enough to meet the liabilities ahead of the common, then the cash will be deducted to meet the balance of the senior claims ahead of it.

The asset-value is not as important as people think, because it has no real relation to earnings power; earning power and dividends are much more important when valuing a stock. But, it should not be ignored; the wise analyst will follow these rules:

1 - a safe bond or preferred stock almost always requires an ample margin of tangible assets over the senior claim, together with adequate earning power.
2 - paying many times the asset value for a common stock may be hazardous. also, purchasing a common stock at only a small fraction of asset value carries with it certain speculative possibilities.
3 - valuing or appraising common stock is dependable when the earning power is not more than the book value. A good combination of factors for purchase of stock include: earning power value, book value, and average market quotations in the past.
4 - a market quotation well under current asset value has significance - either the price is too low or the management needs to change its policies in some way.

The current ratio (assets versus liabilities) should be at least 2 to 1 and should also be compared with others in the same field.

Another measure of financial strength is the acid test. The acid test is: current assets exclusive of inventories should be at least equal to current liabilities.

Bank debt is not a problem in and of itself, but it is frequently a sign of weakness and requires careful observation.

A better way to calculate true earnings than adding up reported profits is to add the increase in surplus (and surplus reserves) and dividends paid. This is advantageous because earned surplus generally includes all gains and losses, while some may have been excluded in the income statement. All voluntary reserves must be included in earned surplus. Be careful not to include the changes in owner's equity that are not caused by earnings and cash dividends, ie. repurchase of shares by the company, extraordinary write-ups/downs of assets. These cases are usually cleared through the capital and capital surplus accounts and do not affect the earned surplus account.

In summary, when analyzing a balance sheet:
- all companies should state the value of their fixed assets for insurance purposes, or supply some other guide to their present value.
- companies on a LIFO basis should also give the replacement value of their inventory
- the statement of capital and surplus should clearly show the real claim of prefereed shares, for principal and back dividends, as against the total fund.