September 21, 1998
Balance Sheet Basics
The balance sheet is what ultimately drives earnings performance. Novice investors often forget that changes in balance sheet accounts eventually result in earnings changes. While most investors scan the changes that occur in balance sheet numbers every quarter and take note of "large" variations in accounts, such as a big increase in shareholders' equity in tandem with a correspondingly large increase in property plant and equipment, an interesting exercise (if only to confirm that balance sheets do indeed balance) is to construct a "sources and uses" table.
This exercise will give the investor an exacting portrait of where the money came from and where it went during a defined period in the firm's operating history. Considering the fact that cash can be generated either by reducing an asset or by increasing a liability -- like selling off property or taking on more bank loans -- the opposite is true when considering the various "uses" of cash that a firm has at its disposal. So, taking a look at the most recent balance sheet of American Standard Companies (NYSE: ASD) would yield the following Sources & Uses Table for the first six months of the year (in millions):
Sources Reduction in goodwill (no cash) $1 Increase in current maturities of L.T. debt $140 Increase in accounts payable $58 Increase in accrued payrolls $28 Increase in other accrued liabilities $114 Increase in reserve for retirement benefits $18 Increase in shareholders' equity $83 (decrease in the deficit) Total Sources $442 Uses Increase in cash and cash equivalents $44 Increase in accounts receivable $160 Increase in total inventories $63 Increase in "other current assets" $18 Increase in "facilities" $31 Increase in "other assets" $53 Reduction in loans payable to banks $37 Reduction in long term debt $30 Reduction in other liabilities $6 Total Uses $442If one were to take this sources and uses statement, expand it into three categories, and then add some more details concerning inflows and outflows, one would basically have a statement of cash flows. Net of the non-cash items and indirect sources of cash, a big contributor to American Standard's pool of cash over the last six months has been equity, with a lot of working capital getting tied up in burgeoning inventory (customers holding off on orders) and receivables.
When investing, it may seem like a great deal of effort is expended with little to show for it. However, it's a process where the person who turns over the most rocks eventually gets rewarded. To put a lot of work into something only to find that it isn't worthwhile can be disheartening, but like love, each failure should be viewed as just another possibility eliminated (although sometimes for just a short spell until the price comes down or until the one doing the spurning realizes what a good thing they had). Similarly, an investor's ability to "stretch" a moneymaking thesis is inversely proportional to the amount of time that is allocated to the endeavor. That is, the less time you have, the more of an emotional investment you place in any one "idea" rather than confronting the grim reality that in most instances it's best to move on.
Someone once said that business is really very simple -- you try and sell something for more than it costs you to produce it. Aside from that, and about a million other details, it's pretty straightforward. Investing is all about the details, and nowhere is this thought better exemplified than in the statement of balance sheet amounts. The numbers that you see in each of the balance sheet accounts above are virtually all the product of management's "best" estimates and judgments.
Taking these numbers as gospel can sometimes be less than financially fattening, and at the very least, investors should be aware of where these judgment areas lie and what is at issue during the course of their calculation. Now, whipping out the magnifying glass and reading the fine print in the financial footnotes can seem like a fruitless endeavor. After all, if you conclude that the expected return on pension plan assets is too optimistic, would you really choose to nix your investment in what would otherwise be an attractively valued company? Perhaps not, but if there happened to be a multiplicity of questionable "judgment calls," you might get the idea that management is pushing a little too hard. On Thursday, we will begin a four-part series that can serve as a checklist of sorts for the types of issues that balance sheet sleuths need to take a closer look at when analyzing financial statements.