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IFB68:A Simple Balance Sheet Primer for Beginners

simple balance sheet

 

Welcome to Investing for Beginners podcast, this is episode 68. Tonight Andrew and I are going to talk about the balance sheet and give a kind of a brief overview of that. We’re also going to talk a little bit about some ratios that you can derive from the balance sheet.

This will be a great primer that you can use to look at 10ks, 10-qs and also kind of combine it with the cash flow statement analysis that we did a while back. Without any further ado I’m going to turn it over to Andrew and he’s going to start us off.

Andrew: so that cash flow statement episode you’re talking about that’s episode 17. We went super in-depth into that one but it was a good overview on the different financial statements and some of the key things you can kind of pullout from that. Last week we talked about basically earnings and what companies do when they get earnings.

We talked about how they can reinvest in the business they can hold the cash they can pay out dividends or they can do they can do share buybacks. The other thing they could do which I forgot to mention is they can use that cash and use those earnings to pay down debt.

And so I think that’s something we should focus on today. I am very anti debt I don’t like to invest in businesses that load on a lot of debt and so on the flip side of that when I see a stock where management has decided to aggressively pay down their debt.

They see using current profits you’re essentially you know not necessarily worrying too much about the short-term you’re really taking a long-term approach and so I really like that one that. When the stock is doing them the last eletter pick that just went out yesterday had a stock that really did that aggressively.

And so that’s something I like to see and I’ll kind of give an overview right so what the bounce she is how do you look at the bounce she obviously it’s very confusing but is there a way to for somebody who’s not an accountant some of these just an everyday person can they really understand what a balance she is I believe you can hopefully this episode will help you do that.

So turn it back to you Dave if you could break down the balance sheet and give us the simplest overview of what it is like if I had to pick three lines from the balance sheet that I want to know which they would be and why.

Dave: three main I guess compartments or you know yeah compartments is probably the easiest way for me to look at it it’s simply both goes down to assets liabilities and shareholders’ equity at a specific point in time.

So when you look at a balance sheet it’s actually a snapshot of what the company owns what it owes and what its worth at that particular time. So if we pick today which is August 2nd then the balance sheet of you know Company A would be have all those items listed in it.

So assets are simply things that generate money for the company whether it’s products whether its inventory whether it’s a physical building there’s all these different aspects that you can really dive into.

Liabilities is what you owe people so when you buy things you order stuff and you wait 30 days 60 days 90 days whatever it may be whatever your contract is to pay those back those are liabilities because those are monies that you have that you have to give to somebody for our product or service that you’ve purchased.

And then shareholders equity is what the equity of the company is worth and all those things add up into the balance sheet.

Now part of the sheet so when you look at a balance sheet the first thing you’re going to see are all the different assets and that includes cash and cash equivalents and all the other assets that we talked about.

Then the next section is going to consider contain the liabilities and again that’s all the stuff you people and then right below that is the shareholders equity.

Now the balance so the balance sheet where the reason why they have to call it they call it a balance sheet is because the assets has to match the liabilities and the shareholders equity.

Those two sections even though there’s three parts to it those two sections assets liabilities shareholders equity they all have to equal each other so the assets have to equal the liabilities and the shareholders equity and that’s really kind of how it breaks down.

Now there are obviously some very specific things that you can look at in the balance sheet under the assets and under the liabilities another two shareholders equity and we can talk about those maybe sometime in the future. But today we just kind of wanted to give you a more of a snapshot of kind of how that works.

When you look at the balance sheet those are really the main three items that you’re looking for what does the company what are their assets how they making money what are the liabilities who do they owe and how much do they owe and a shareholder’s equity how much does a company worth so that’s really kind of how it breaks down.

Andrew: I think that’s key and something that gets lost a lot and I think that makes a balance sheet confusing and then once you understand this part of it then really that’s kind of when it made sense to me.

I’m just going to highlight it and just repeat what you said Dave and basically, it is that all that shareholder’s equity is the difference between your assets and your liabilities so if you have more assets than you have liabilities then you have a positive shareholders equity.

In the value investing world you’ll hear shareholders equity is also referred to as Book value and so all a big way that you can think about shareholders equity if it’s real asset – liabilities then it’s the same as a regular person who has assets and liabilities.

And in that sense the difference between your assets and your liabilities is your net worth and when I put that connection together the shareholders equity kind of really tells you like what the net worth of a company is it’s not obvious it’s not as simple as saying well that’s the valuation that’s what the company is worth there’s more to that.

But from a basic premise, you can say that if the company were to completely let’s say tomorrow all business shut down and you had to give back the one you had to give back to owners everything that the company is worth you would liquidate the assets divvy those up pay off the liabilities. What you would have left is the shareholders’ equity and that would be the total value of the business.

I also want to make the distinction that when it comes to assets you can break them down into the two main categories so you have income producing assets and non-income producing assets. If I go back and circle around to taking the average person right an asset can be anything that helps you make money.

Let’s say you drive to a job and you have to commute you can say that your car is an income-producing asset because it helps you eventually earn a paycheck maybe you can fight me on that I don’t know I think it’s a simple way to look at it.

Another example would be if you work from home and you have a computer with an internet connection you know at least the computer itself would be an asset and you if you use it to create income by working on the computer then that’s an income-producing asset.

Examples of a non-income-producing asset would be like straight-up cash or you could say like someone’s clothes could be a non-income producing the asset in the sense that essentially if you can trade it for cash I believe then you can consider it an asset because if you can trade that for cash then trade it for cash and then you can use that cash to either buy an income-producing asset or just have it sit in your bank account and it still counts as an asset as a piece of cash and that’s going to up your net worth.

So those are kind of the different ways you can think about assets when it comes to like a particular balance sheet they have cash and cash equivalents on the balance sheet they’ll also show things like short-term investments they’ll show things like marketable securities we’ve talked about marketable securities in the past.

But you know just like an everyday person can go out and buy stocks a business can go out and buy stocks Warren Buffett buy stocks through Berkshire Hathaway which is his corporation that he uses their cash to buy stocks.

If you start to think of the balance sheet in that way it’s simply what people what they own where the corporation owns and either it has a value it has a resale value in exchange value or it creates income in some way then it’s most likely going to be in the balance sheet.

The next kind of thing I wanted to go over when it comes to the balance sheet we’ve talked about the assets what’s important to talk about next is the liabilities and something that again I think it gets lost and this is something not even beginners might not understand the complexity or the implications that this has.

But I believe a lot of like good investors I believe a lot of investors who initially have good results I believe a lot of investors who are maybe very aggressive they don’t truly understand how debt can really cripple a business and how much debt really tells you about the health of a business and when I say the health I’m really talking about the long-term health.

It’s easy to say that business is healthy when things are going well and when the economy is booming well every business is doing well that’s not going to be hard to find. But when things kind of tighten up the belt tightens expenses need to be cut earnings go down you know profits are down people aren’t at the malls all the sorts of things.

simple balance sheet

Then that’s when you’ll start to see who really has the strong business who really has the healthy financials who has a strong balance sheet and who has a solid foundation versus who doesn’t.

I talked about this on the daily email the other day and I kind of broke it down and I use like a hypothetical I won’t get into the exact numbers because that’s going to be hard to follow in the podcast but I used like just a random number I took like an average return on equity so like 15%.

And then using that I I calculated an earnings number and then I looked at debt to equity and I tried to show that a high debt to equity will actually make it hard for a business to retain any sort of profits.

Again if we go back to what we talked about last week the company will make profits and then they will have various options that they can use for those profits but you know if they have a lot of debt and they’re having to make a lot of debt payments then instead of being able to give the money back to shareholders instead of being able to reinvest in the business instead of being able to pay off debt.

They actually have to use those earnings to just make their debt payments and that’s going too really cripple if you think about it really cripples the long-term health of the business because it’s not going to have the ability to really grow earnings like a business who has little debt.

And you know let’s compare two businesses right one business has a lot of debt with high debt payments they might make a lot of earnings but if 75% of those earnings are going back to pay off debt then they only have 25% of their earnings to really use and compound and you know use to buy more assets which can make more profits.

You go on the flip side and you look at a company who might not have like super strong earnings at the outset but if they have little amounts of debt they can basically cash flow all of their profits let’s say they’re reinvesting 90 percent of those profits back in the business well you’re going to almost double your amount of business every year.

You can keep the same amount of return on equity and you’re buying new income producing assets you can really start to see some accelerated growth and really see some compounding work its magic within the business when you have low debt levels.

There’s a couple ways you can calculate debt to equity in an example with the daily email I used long-term debt to equity I found something as small as like a 2.0 long-term debt to equity meant that if you look like an average 5% interest rate on the business loan and you can do all of this on your own with like a business loan calculator and then you can do hypothetical amounts and like a 5% interest rate.

Basically what I found if somebody has an average return on equity they have a long-term debt to equity of 2.0 they’re not going to make enough and earnings to even pay their monthly payment on their on their long-term debt so that’s going to be really problematic.

Obviously not sustainable I don’t know how you get growth from that and so looking at the balance sheet can really help you not to say it’s a perfect measure but I think if you stack all the all the odds in your favor you put all the best cards in your hand.

Then by buying by buying stocks with these balance sheets that have little amounts of debt, I think that really prepares you for over the long term. You might not see it in a year you might not see it in two years but over the long term a company with lower debt will probably have a higher ability to compound their earnings a higher ability to really maintain a higher amount of retained earnings and that can do huge things for the stock price for the earnings for the growth of the business all those sorts of things for the very long term.

And I don’t really see it talked about a lot and so I know I always focus on well high debt is very risky and it leads to bankruptcies and nobody wants to hear that. So let’s talk about the other side let’s talk about growth and understand that in the same way that it can really cripple a busy one struggling. It can really hinder growth even when the company is doing well because it just makes sense like if you just say.

A quick aside if you look at the accounting tax rules on the ways that they the ways that they have to make payments on their loans so they have like interest expense and so the interesting part is able to be taken off the P&L; but the principal part that they’re paying off on the debt has to come out of earnings.

Essentially what that means is everything I’ve been talking about up to now if a company has a lot of debt if they’re making high debt payments that are lowering their overall profitability and so you want to talk about growth let’s talk about growth I want to be in businesses with low debt levels because those will have higher amounts of reinvestment available to potentially grow much higher much faster and much better scale over the long term and you won’t see that from year to year and I think that’s why it’s really not talked about a lot.

Dave: I would definitely agree with that I think not looking at the debt and how it works I think that’s fascinating I honestly never thought of that before about the calculations of looking at what the payment would be and whether they have enough earnings to cover that that was actually kind of fascinating I think that was a very astute observation you made.

Andrew: it was originally I didn’t take that from a book or anybody that’s right it’s just bid that you got that figured that out of it yeah it started moving.

Dave: so I guess my question for you then is we’ve talked we talked before about debt to equity ratios so when you calculate a debt to equity ratio do you look at do you combine the short term and the long-term debt or you just look at the long-term debt or do you just look at the short-term debt?

Andrew: okay so this this can be tricky because you asked five people they’re going to give you five to four answers you look at five different websites to give you five different answers right the debt to equity ratio is essentially trying to relate how much debt a company has and compared to their shareholders equity or their book value and you want to have obviously a lower debt to equity ratio is better because that says you have less debt you have more assets to cover your debt.

The way I calculate it is I just take all of the liabilities and I take all of the shareholders equity and that’s how I calculate it so it’s very simple or not look I’m not digging into the balance sheet because you have all these sorts of different like you said short-term debt long-term debt you got expense this expense that all these different line items.

In my mind I want to find businesses that have good business models where they don’t need to be paying out a lot you know you can have a business that is five hundred and billion dollars but if it takes some 499 billion dollars because they have to build all these expensive factories I have to hire a bunch of lawyers and expensive or to be on their force well that’s not a lot of profit right.

We want to stay away from businesses like that and that’s why I take a conservative approach but I think as an investor who’s kind of navigating the metrics and trying to learn what these balance sheet ratios are you have to understand that everybody’s going to calculate it a little bit differently.

I think a very common way to calculate that to equity is to take the long-term debt and then they just all these debts equity ratios are just taking the debt on the top part you’re dividing it by the equity on the bottom part and that’s your ratio what they’re doing is they’re taking like long-term debt and then they’re comparing that to equity.

That’s what I did in my daily email just to show you how because the long-term debt was easy right like a long-term debt would be something like a bond and bond rates historically I’ve been somewhere four five six percent. I mean they fluctuate a lot but that’s kind of a safe range of a historical bond rate so that’s why I was able to come up with like a monthly bond payment that a company would be making.

But a lot of these I think Finviz is that’s an equity ratio uses long-term debt so you know I kind of makes sense because some business models are different and like short-term debt usually you won’t be paying a lot of interest on it right. So people want to they want to figure out which businesses are paying a lot in interest and they’re trying to stay away from those by using long-term debt-equity so that makes sense to a degree.

But kind of like the way we always talked about on the podcast right invest with a margin of safety emphasis on the safety we’re always trying to get the steepest discounts to intrinsic value the most solid businesses with the greatest competitive advantages the strongest balance sheets we can find and so I’m always conservative with my calculations and this is one example of that and that’s kind of why.

Dave: and I you know I think I thank you for explaining that to me it makes complete sense because when you look at the liabilities on a balance sheet you’re really looking at sure you know what they call current liabilities and long-term liabilities.

But if you’re looking at all of them it solves is all money that somebody has to pay at some point and you know and it doesn’t just do you know you know I as a banker think of debt as a loan and it’s more than that. it’s more than you know just the five hundred dollars you borrow from somebody you got to pay it back it’s more than that.

It’s the interest that you earned on that but it’s also things like rent and taxes and wages and dividends you know when all the companies that we talk about you know they have dividends that are payable and so that has to come from somewhere and that’s money that’s being taken out of earnings to be given to us and that’s a debt you know that’s a liability.

That’s not money that company gets to keep and use for their own purposes whether it’s you know lining the CEOs pocket or you know using it to reinvest in the company and to me that’s a liability and it should be calculated as part of a debt to equity because it’s debt.

So many people I think of debt as a loan and that’s all they think of and I like the way that you explain that and looking at the total package of liabilities of all the different things you know deferred tax liabilities. Let’s say that the company doesn’t pay all their taxes one year while they’re setting aside money to pay it in the future whether it’s long term or short term but that’s still money they can’t use it’s still a debt it’s whether they’ve paid it or not it’s still money that they owe to the government.

And it’s certainly a liability and so I think the way that you calculate it to me is by far the most conservative and I really like that idea because as you said it helps with a margin of safety and I guess you know talking about ratios we’ve obviously delved quite deeply into the debt to equity let’s talk a little bit more about some other ones so tell me a little bit about price to book and price to cash.

Andrew: yeah so when it comes to the balancing ratios these are the other ones you can calculate and they’re pretty simple pretty easy we mentioned earlier book value is the same as shareholders equity so if you want to take price to book that’s one of the valuation metrics we talked all about valuation metrics in one of the previous episodes we gave like a guide and kind of gave an overview of why they are important so I won’t go all into the nitty gritty about that.

That was episode 11 that had all the price based valuation metrics ever talking about. So price to book price to cash those both those both are discussed in depth in episode 11.

But you can just look at the balance sheet and calculate it very simply all you need is just like the debt to equity is debt divided by equity price to book is debt divided by book value. So you attend you would find the book value by looking on the balance sheet looking at the shareholders’ equity that’s your book value and then you could take the market capitalization which is the price of a company times its shares outstanding.

There are two ways you can do it you can do price the price of the share price divided by the book value per share or if you’re looking at the complete picture then you add the shares outstanding and you would get the market cap divided by the book value.

If that’s something that doesn’t make sense to you then check out the blog and I go over that in depth it might be easier to learn over text. And the price to cash is really the same way one of the line items in the balance sheet is cash and cash equivalents.

It’s that same line item that I use when I’m calculating net cash from the cash flow statement so if you go back to episode 17 we talked about the cash flow statement. I talked about why I like to use price to cash and so I call it net cash they also call it cash at the end of the year on the cash flow statement and it’s referred to in the balance sheet as cash and cash equivalents.

And so in the very same way you can take for the price part on the top you take market capitalization on the bottom you just take cash and cash equivalents from the balance sheet and that gives you the price to cash ratio and so those are three really great metrics that you can use to find businesses that a are strong fundamentally they don’t have too many liabilities so they’re not too overloaded with debt they don’t have liquidity problems if things go bad and they’ll have greater chances to kind of grow and compound their wealth over time.

And then the second one price-to-book help you find you know helps you pay a fair price buying with a margin of safety emphasis on the safety getting a discount on that intrinsic value. So a price to book makes sure you’re getting a lot of assets for what you’re paying for whatever the stocks trading that at the time.

And then price the cash same thing just make sure you’re buying businesses that have a decent amount of cash because you don’t want businesses just to reinvest everything it has no cash because if things go bad or even like if an opportunity shows up where they could have acquired a great business but they have no cash to do it. Either they’re going to have to take out there or they’re going to have to pass on the opportunity so it’s good to have at least a reasonable amount of cash that a company can have.

And so price to cash makes sure that you’re buying companies that aren’t too expensive and that have decent amount of cash in their coffers if you will and this is so those are the three main ones that you can calculate using the balance sheet and I believe that will cover like 95% of what you really need to know when it comes to looking at the balance sheet making simple observations and making a basic analysis and figuring out if it’s strong if it’s weak if you like it or if you don’t.

Alright, folks well that is going to wrap up our discussion on balance sheet and some of the different ratios that you can derive from it.

I hope you enjoyed our overview and if you had any questions about the balance sheet, please reach out to us and let us know we do have to give you a little more guidance on that. There is so much that you can dig into on all the different financial statements when you’re looking at a company and this is just kind of an overview of the balance sheet.

So without any further ado I’m going to go ahead and sign us off you guys have a great week go out there and invest with a margin of safety emphasis on safety, and we’ll talk to you guys next week.

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