Testing Balance Sheet Strength
For stock investors, the balance sheet is an important consideration for investing in a company's stock because it is a reflection of what the company owns and owes. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capitalization structure.
In this article, we'll look at four evaluative perspectives on a company's asset performance: (1) the cash conversion cycle, (2) the fixed asset turnover ratio, (3) the return on assets ratio and (4) the impact of intangible assets.
The Cash Conversion Cycle (CCC)
The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. In addition, the CCC is equally important as measurement of a company's ability to efficiently manage two of its most important assets - accounts receivable and inventory.
Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter this cycle is, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than tying up unproductive working capital in assets.
CCC=DIO+DSO-DPO
Where;
DIO- Days Inventory Outstanding
DSO-Days Sales Outstanding
DPO-Days Payable Outstanding
There is no single optimal metric for the CCC, which is also referred to as a company's operating cycle. As a rule, a company's cash conversion cycle will be influenced heavily by the type of product or service it provides and industry characteristics.
Investors looking for investment quality in this area of a company's balance sheet need to track the CCC over an extended period of time (for example, five to 10 years), and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in inventory on hand are generally not positive investment-quality indicators.
The Fixed Asset Turnover Ratio
Property, plant and equipment (PP&E), or fixed assets, is another of the "big" numbers in a company's balance sheet. In fact, it often represents the single largest component of a company's total assets. Readers should note that the term fixed assets is the financial professional's shorthand for PP&E, although investment literature sometimes refers to a company's total non-current assets as its fixed assets.
A company's investment in fixed assets is dependent, to a large degree, on its line of business. Some businesses are more capital intensive than others. Natural resource and large capital equipment producers require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers generally have around 30-40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries.
The fixed asset turnover ratio is calculated as:
Fixed Asset Turnover = Net Sales/Average Fixed Assets
Average fixed assets can be calculated by dividing the year-end PP&E of two fiscal periods (ex. 2004 and 2005 PP&E divided by 2).
This fixed asset turnover ratio indicator, looked at over time and compared to that of competitors, gives the investor an idea of how effectively a company's management is using this large and important asset. It is a rough measure of the productivity of a company's fixed assets with respect to generating sales. The higher the number of times PP&E turns over, the better. Obviously, investors should look for consistency or increasing fixed asset turnover rates as positive balance sheet investment qualities.
The Return on Assets Ratio
Return on assets (ROA) is considered to be a profitability ratio - it shows how much a company is earning on its total assets. Nevertheless, it is worthwhile to view the ROA ratio as an indicator of asset performance.
The ROA ratio (percentage) is calculated as:
ROA= Net Income / Average Total Assets
Average total assets can be calculated by dividing the year-end total assets of two fiscal periods (ex 2004 and 2005 PP&E divided by 2).
The ROA ratio is expressed as a percentage return by comparing net income, the bottom line of the statement of income, to average total assets. A high percentage return implies well-managed assets. Here again, the ROA ratio is best employed as a comparative analysis of a company’s own historical performance and with companies in a similar line of business.
The Impact of Intangible Assets
Numerous non-physical assets are considered intangible assets, which can essentially be categorized into three different types: intellectual property (patents, copyrights, trademarks, brand names, etc.), deferred charges (capitalized expenses), and purchased goodwill (the cost of an investment in excess of book value).
Unfortunately, there is little uniformity in balance sheet presentations for intangible assets or the terminology used in the account captions. Often, intangibles are buried in other assets and only disclosed in a note to the financials.
The dollars involved in intellectual property and deferred charges are generally not material and, in most cases, don't warrant much analytical scrutiny. However, investors are encouraged to take a careful look at the amount of purchased goodwill in a company's balance sheet because some investment professionals are uncomfortable with a large amount of purchased goodwill. Today's acquired "beauty" sometimes turns into tomorrow's "beast". Only time will tell if the acquisition price paid by the acquiring company was really fair value. The return to the acquiring company will be realized only if, in the future, it is able to turn the acquisition into positive earnings.
Conservative analysts will deduct the amount of purchased goodwill from shareholders equity to arrive at a company's tangible net worth. In the absence of any precise analytical measurement to make a judgment on the impact of this deduction, try using plain common sense. If the deduction of purchased goodwill has a material negative impact on a company's equity position, it should be a matter of concern to investors. For example, a moderately leveraged balance sheet might look really ugly if its debt liabilities are seriously in excess of its tangible equity position.
Companies acquire other companies, so purchased goodwill is a fact of life in financial accounting. Investors, however, need to look carefully at a relatively large amount of purchased goodwill in a balance sheet. The impact of this account on the investment quality of a balance sheet needs to be judged in terms of its comparative size to shareholders' equity and the company's success rate with acquisitions. This truly is a judgment call, but one that needs to be considered thoughtfully.
Conclusion
Assets represent items of value that a company owns, has in its possession or is due. Of the various types of items a company owns; receivables, inventory, PP&E and intangibles are generally the four largest accounts in the asset side of a balance sheet. As a consequence, a strong balance sheet is built on the efficient management of these major asset types and a strong portfolio is built on knowing how to read and analyze financials statements.
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