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How to stress test a balance sheet?

The balance sheet is like the engine for the company, it doesn’t matter how good the earning numbers are or the cashflow company is generating if the engine is broken it can’t go any further. Therefore, before investing in a company one should diligently look into the balance sheet of the company.

The balance sheet depicts the financial health of the company and the strength of the balance sheet is the only thing that matters during uncertain times.

Here are key parameters within which you can test the strength of the balance sheet-

1) Leverage is good?

Debt gives you wings to fly but only in good times. Debt can be useful when the economy is doing good and there is strong demand at the consumer end. In a bull market, debt helps you to earn a higher return on your investment. How does debt help to earn higher on your investment? Look into the example below-

Suppose you want to buy an asset for INR 100 Cr but you have only INR 30 Cr and financed the rest INR 70 Cr from a bank. Assuming times are good and consumer demand is strong, the asset price triples in value to a worth INR 300 Cr. You could sell the asset and repay the loan of INR 70 Cr. Therefore, you will generate a higher return on your investment.

Return on Equity or capital (ROE) = 270/30 = 9 times return

Without debt, the return wouldn’t have been so high. The extra 3 times is the leverage that the company got because of debt.

However, if times are bad, these companies struggle to survive and ultimately have to shut down their business.

Here’s what Buffet has to say- “You never know who's swimming naked until the tide goes out.”

Therefore, as a minority shareholder, it is always advisable to stay away from companies that have high debt on their balance sheet.

2) Capital Investment used efficiently?

Companies that are fundamentally strong tend to have a good fixed asset turnover ratio. The fixed asset turnover ratio depicts the company’s ability to generate sales with the help of capital investment. Since assets can cost a significant amount of money, therefore, investors should pay close attention to whether the company is able to generate sales with the fixed asset purchased. A high ratio indicates that the company is using the assets efficiently and a low ratio indicates vice versa.

Fixed Asset Turnover Ratio = Net Sales/Average Fixed Assets

The higher the ratio better it is. Also, compare this number with its peers.

3) Are debtors balance rising?

This should be a concern and an indication that the company is not able to realize the debtor’s balance in cash. However, if you look into the Income statement, it might give a faulty signal, sales might rise despite weak collection from its debtors. In this kind of scenario, it pays off to look into the revenue recognition policy of the company. Some companies recognize revenue aggressively. You will find it in their notes to accounts.

You can also get an idea on the collection of debtors with the help of days sales outstanding ratio, this ratio indicates the number of days a company needs in order to convert credit sales into cash.

DSO= (Account Receivables/ Net Credit Sales) *365

DSO below 35-40 days is low and a great sign on the collection capability of the company, however, a high or low DSO depends upon business to business.

Therefore, rising debtor balance should be a concern for long term investors.

4) Red flags to watch in the Equity and Liability Side

One of the greatest red flags in a company can be negative retained earnings as it indicates that the company has been accumulating losses over the last few years.

Another red flag can be negative equity, sounds strange but this happens when the deficit in retained earnings is higher than the equity capital of the company. In this case, either the company has to raise fresh capital or file for bankruptcy. It’s a rare case but stay away from a company that might get in this zone anytime soon.

A strong balance sheet is what defines a company and its fundamentals. Having more assets than liabilities is the simplest way to judge a balance sheet whether it is strong or weak. Also, a company with a strong balance sheet are those which are structured to support the entity’s business goals and maximize financial performance.

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