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Pt. 2: Balance Sheet Equation and Ratios

The last post showed you how simple balance sheets can be. Now we are going to examine a bit further into another important balance sheet equation, as well as a couple of examples to see if we can understand every last detail. If you haven’t seen part 1 of this post, be sure you check it out.

balance sheet equation

So the first thing to understand is that balance sheets will differ from industry to industry. The balance sheet of an insurance company, for example, will vary in the line items from one of a retailer. Their business models are just so different.

But there are 3 important line items that every single balance sheet shares. It’s really the only 3 categories I’ll look at when I am analyzing and comparing stocks. Those 3 are:

1. Total Assets
2. Total Liabilities
3. Shareholder’s Equity

If you were paying attention, these are the same 3 I talked about in Part 1: Simple Balance Sheet Analysis. So of course, we have to know about them because they add up all of the other rows of the balance sheet.

Assets are pretty self explanatory. They are anything that the company owns that has value, and that can be sold for cash. Think of things like inventory, real estate, and even just straight up cash. Yes cash is an asset.

Liabilities are anything that the company owes. Whether that’s short term or long term debt, or accounts payable. Anything that a company is financially responsible for goes in the liabilities section.

Finally we have shareholder’s equity. It’s called shareholder’s equity for a reason, because it is the equity that shareholders are entitled to. Like I mentioned in part 1, this is one of our golden eggs. It’s a very tangible way to see how much value we are getting in a stock.

Balance Sheet Equation

Now I already explained how we can use the P/B (or price-to-book) ratio to find value in the balance sheet with the part 1 post. But there’s another helpful balance sheet equation that we can use to evaluate companies.

This ratio helps us minimize risk. Period. Companies with more debt are more risky, it’s so simple yet so many people forget it. But it’s not just total debt numbers. Instead, it’s all about how much debt does a company have compared to its assets and equity? If we had a way to find this out, we could avoid the riskier companies. [I talk about this in my 7 Steps to Understanding the Stock Market guide].

Debt to Equity ratio tells us exactly this. There’s several ways to calculate Debt to Equity ratio, but I like to use the simplest version. It’s the most useful because it covers our backside in case of strange accounting gimmicks. I use this balance sheet equation:

Debt to Equity = (Total Liabilities) / (Shareholder’s Equity)

Some people just use short term debt to calculate this value, but why do that? Don’t we want to know all of a company’s debt? What if they are just stacking all their debt short term, or long term?

A simplified equation like this one prevents us from getting blindsided by an accounting trick. And it lets us see the whole picture, and get a consistent ratio throughout all companies (this is because the GAAP accounting rules of the U.S. require every company to submit total assets, liabilities, and shareholder’s equity numbers).

As a general rule of thumb we always want a company that has a Debt to Equity of less than 1. Why? It makes sense when you think about… any company with a debt to equity over 1 has more debt than their equity. So if all their debt was called tomorrow, they’d be bankrupt. Is that a situation you want to get in to?

Of course, we are talking about extreme and worst case scenarios, but who really would’ve thought that a big bank like Lehman Brothers would’ve failed? I’d prefer to be safe rather than sorry, and I think you should be too.

Now the one caveat to the debt to equity rule is that many financial companies keep their debt to equity ratios around 10. So they are about 10 times more leveraged than the average company (with a debt to equity around 1). Financial companies are banks and insurance companies.

But just because all the cool kids are doing it, doesn’t mean we should just blindly follow the blind. For example in the insurance industry, I’ve found several companies with much lower debt to equity ratios than 10. All trading in the S&P 500. Don’t be afraid to turn over more rocks.

Proof about Debt to Equity

I realize I can tell you on and on about how good debt to equity ratio is. But it’s better to just show you. So here you go.

Check it out, the debt to equity for several recent big name bankruptcies:
Lehman Brothers 29.7
Circuit City 1.49
Border’s -7.2
Enron 4.7
Countrywide Financial 13.4

No surprise that the top 2 are financial companies. But look at a company like Border’s. They had a negative debt to equity! Which means they didn’t have any equity, they had a deficit! Why any investors were surprised by this one is beyond me.

Look even at a company like Circuit City. Sure a debt to equity barely above 1 doesn’t look all that bad. But look what happened to them.

See, this is why I shoot for companies with a debt to equity of 0.25 or less, if I can. At the very least less than 0.5. You always want to know that a company is well equipped to survive a recession or depression.. or how are you going to sleep soundly otherwise? Debt to equity makes it all clear.

Balance Sheet Explanation by Section

Ok, so now let’s dive into the nitty gritty. I’m going to show you 2 real balance sheets, from 2 very different industries.

Before I get into it, realize that I’ve already taught you all that you need to know at this point. With the material from part 1 and the material above, this is everything that I use to evaluate my stock buys.

But it can be enlightening to learn even more about how these balance sheets function. If you can get even more educated about the small details of a balance sheet, you can have a greater appreciation for the most stacked solid balance sheets (like when you can recognize that a company has a bunch of great real estate on paper or when you can differentiate between a company with a little too generous goodwill).

Take an insurance company like AIG. Let’s peek at their balance sheet.
Screen Shot 2014-08-27 at 9.21.38 PM

Screen Shot 2014-08-27 at 9.21.48 PM

(Attribution: SEC.gov)

Looking at the first couple of rows, we see that they have a very detailed “investments” section. This might be news to you, but many companies also hold investments such as stocks and bonds as a part of the assets (especially insurance companies). This part should be pretty self-explanatory. You can see they have some bonds, common stock, preferred stock, and more.

Moving on we see “premiums” which would be like the inventory of a regular company (that is, if that company’s inventory was all already sold out).

It’s actually pretty significant that we see premium in the balance sheet. That’s a special case for insurance businesses that gives them an advantage over others. For example, if a normal retail company sells some inventory, they lose that inventory from the balance sheet but gain revenue and profit in the income statement. So you see the business continues to run because it is able to keep charging more for their inventory than what it is worth, thus the sustainable business.

Insurance is unique in that their revenue doesn’t take from the balance sheet. You’ll see later that it does show up on the liabilities side, but as they continue to make more sales (increase their client base), their premiums category will grow. Which allows more money to be invested, which grows the total assets column even more.

If you’re really interested in this special business model and how you can take advantage of it as an investor, you can get more information about that here.

As far as the assets side goes, this is all that we really need to worry about here. Keep in mind that this balance sheet looks vastly different than most other balance sheets are. To see more of a normal one, look below. We can see how much of an insurance company’s assets are really just on paper, but this allows for some really efficient uses of their capital.

Now let’s contrast that with the balance sheet of a famous retailer like Amazon (AMZN). Here’s what that looks like.

Screen Shot 2014-08-27 at 9.26.35 PM

Screen Shot 2014-08-27 at 9.26.49 PM

(Attribution: SEC.gov)

First things first, notice how much simpler AMZN’s balance sheet is. This makes sense because they have a pretty simple business model. They just sell things. Stock product, sell it. Whereas a company like AIG sells derivatives, and worries about float, and such.

Cash and cash equivalents, along with marketable securities, basically make up the cash reserves of the business. This cash can be taken out of the balance sheet and implemented into the business whenever needed. Inventories and accounts receivable are required to run the business, and are pretty self-explanatory.

Property and equipment can be useful because it can find us cases when companies have stronger assets. Usually this category is split up so that you can see the property and equipment numbers independently. You must understand that property values tend to appreciate in value while equipment tends to depreciate over time. This makes sense because machines break down and need to be repaired or replaced, while the real estate market has been in a strong uptrend for almost a century. I like to buy companies with a lot of property on their balance sheet for this reason. It’s almost as if you are getting real estate exposure along with the cash flow created from the business.

Finally, we have goodwill. Goodwill makes up for any other value that the company may have that can’t be exactly quantified with a number. Also oftentimes grouped with intangible assets on the balance sheet, goodwill can be anything from a company’s competitive advantage to its brand. A company like McDonald’s, for example, has goodwill because it is a household name and this brings more sales to the business. A company like Amazon has goodwill because of its competitive advantage of superior cost cutting with cheap manufacturing and shipping. This category can be manipulated by accountants (this doesn’t frequently happen as of yet) because it is so vague, so be careful if a company has most of its assets or a high percentage as goodwill. It could just be an excuse for loose management.

In Conclusion

With a rock solid understanding of the balance sheet, you can actively find great value stocks and avoid big risk names like the Lehman Brothers of yesterday, or the Clorox of today. Unfortunately, most investors don’t take the time or effort to learn something as fundamentally basic as this. Fortunately for you, this presents an opportunity and an advantage.

Don’t get swiped by the tide. Build your rock, and make it steady. I know it isn’t as fun, and I know at times it isn’t sexy. There’s “fortunes being made” right now in companies like Clorox, Moody’s, Netflix, and Tesla. But there were also “fortunes being made” during the internet stocks of the late 90s.

The funny thing about “obvious” finance is that it’s only obvious after the results are in.

It was only obvious to everyone that the Dot Com stocks were built on a flimsy foundation after the waves swept them away. In the same token, these stocks I mentioned before are built on the flimsiest of basic foundations. They have ridiculous P/B ratios that are completely unsustainable. They have careless Debt to Equity ratios that just waiting for a freak accident. It’s a house of card waiting to happen.

I’ve given you these basic tools to understand balance sheets. Now use them. Analyze for yourself.

…and then, just wait. Fortunes that are built to last take a long time. Like the trees built decades before them. But the fruit they bear will taste sweeter when it’s built on a solid foundation.

**Pt. 2: Balance Sheet Equation and Ratios**
**All Rights Reserved. Investing for Beginners 2014**

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START FROM THE BEGINNING:
1. How to Read Annual Reports for Beginners
CONTINUE READING THE GUIDE:
2. Simple Balance Sheet Analysis
3. Line-by-Line Balance Sheet Breakdown
4. Simple Income Statement Analysis
5. Line-by-Line Income Statement Breakdown
6. Simple Cash Flow Statement Analysis
7. Line-by-Line Cash Flow Statement Breakdown