PETER LYNCH 00:00
Any company’s operations can hit an air pocket from time to time. You got to make sure your company can survive tough times. The balance sheet tells you about the company’s financial structure, how much debt it has, how much cash it has, and how much equity its shareholders have.
There is nothing scary about a balance sheet. No story is complete without a check of the balance sheet. The basic concept of a balance sheet is that everything a company owns, its assets, are listed on one side. On the other side you find everything a company owes, its liabilities. The difference between what it owns and what it owes is its equity. Also called its net worth.
Go ahead and explore this fictional balance sheet. Click any of the items on this balance sheet for an explanation of it. When you are ready to move on, click either the debt or cash buttons for a discussion of the two most important items on any balance sheet.
Does the company have a lot of cash on hand, that’s great? A company with a lot of cash can buy more stock, make an acquisition or pay off all its debt. All moves that shareholders love to see.
A company should have at least enough cash to pay off its short-term debt. If it doesn’t, it could have to keep borrowing more and more. If you subtract cash from short-term debt and long-term debt and the total is only one quarter of net worth, the company has a decent balance sheet.
However, if short-term debt and long-term debt combined minus cash equals or exceeds net worth, then the company has a weak balance sheet. It is simple to recognize a strong balance sheet. No debt and lots of cash.
Suppose a company has 20 million dollars in cash after subtracting all debt. If the company has 4 million shares outstanding, it has 5 dollars of cash per share of stock. If you buy the company at $10 a share, you are paying only $5 for the company and you are getting $5 a share in cash. That is a really amazing price. In fact, that means your real price is $5.
If this company has a very solid predictable business, this extra cash is quite valuable. But if the company has lots of cash and is losing money, you still have to evaluate how quickly will they run through all that cash. That is all you really have to know. It is not much, but you should know it. You can look it up in the Stock Shop.
If you don’t check your company’s survivability, you are not only skimping on your research, you are gambling. That is not why you invest in the stock market.
Check the debt. Most companies have some debt. But how much is too much? Add up the company’s long-term debt and total equity. That’s a good approximation of the company’s total capitalization, the money the company has available to grow its business in the future.
Now, compare the long-term debt to total capitalization. If total debt equals half of the company’s capitalization or more, beware, that’s quite a bit of debt. To service that much debt everything has to work right. Things don’t always work just right. If debt equals 20% of capitalization or less, that is better. That’s fairly low debt.
As usual, there is no rule without some exception. Debt in some industries like banking insurance and financial services routinely runs much higher than 20 to 50%. Know the industry and what is normal for it when you evaluate a balance sheet.
In many industries such as retailing and restaurants, companies have leases. They have commitments on buildings to rent for long period of time. Often, this form of debt will only appear in the footnotes. This is a very substantial form of debt. Look into the footnotes. See if you can see capitalized lease obligations. Add this back. This is an important exercise.