There are still economic headwinds pushing against your companies right now: the limited availability of credit, continued deleveraging, and high unemployment, just for starters. Now more than ever, investors must be mindful of companies' financial strength.
This takes us to the balance sheet. It is critical that companies you invest in right now -- particularly small companies -- have strong cash positions, low or no debt, and/or ensured access to credit. In this environment, strong capital positions are very important even while companies are at the early stages of positioning themselves for growth. So while you're looking for those companies that are or will soon begin creating profits, you should also look for the ones that have preserved capital and have better positioned themselves financially for stronger economic growth ahead.
Testing financial strength
There are a number of ways to test balance-sheet strength. The first is cash. Cash is always king -- and now, as far as investors are concerned, cash is the messiah. Always look at how much cash is on a company's balance sheet. Look to see if the company has increased its cash position since last year. You can also measure a company's health by calculating its current ratio (current assets/current liabilities), which measures its ability to pay off its short-term obligations. A high ratio, certainly greater than 1, is desired here.
The next point of examination is the amount of debt the company carries on its books. There are a number of ways to measure this; the most common is the long-term debt-to-equity ratio. A ratio of 1 would mean that the company's creditors finance $1 for every $1 of equity the stockholders give. In this environment, the lower the ratio, the better, as refinancing can be painfully expensive and can increase default rates.
With these guidelines in mind, I sought to uncover companies with strong balance sheets by running a screen using The Motley Fool's CAPS screening tool. I searched for companies with:
- Current ratios of 1 or greater.
- Long-term debt-to-equity ratios of 1 or less.
- CAPS ratings of five stars, the highest.
- Market caps of $250 million or greater.
Here are results from my screen:
|
Company |
Market Cap (in billions) |
LT Debt-to-Equity Ratio |
Current Ratio |
|---|---|---|---|
|
ABB |
$42.9 |
0.17 |
1.7 |
|
Air Products & Chemicals |
$14.6 |
0.74 |
1.3 |
|
American Oriental Bioengineering |
$0.33 |
0.30 |
3.7 |
|
Brookfield Infrastructure |
$0.39 |
0.18 |
12.0 |
|
Cal-Maine Foods |
$0.77 |
0.33 |
2.3 |
|
China Security & Surveillance Technology |
$0.47 |
0.13 |
1.9 |
|
Endo Pharmaceuticals |
$2.6 |
0.05 |
1.9 |
|
Johnson & Johnson |
$174.2 |
0.16 |
1.8 |
|
PepsiCo |
$97.5 |
0.48 |
1.3 |
Data from Motley Fool CAPS. LT = long-term.
Balance-sheet strength is a critical element to look at when researching companies. However, it's only one factor. Investors must remain mindful of the industry in which the company operates and whether that industry has growth potential. From there, you must assess the company's position within the industry. Is it a leader? If not, does it have a product or service that is gaining traction in the market to help it gain market share? These are just some of the questions to ask.
Start finding the strongest companies for your portfolio at Motley Fool CAPS today! Let the collective wisdom of our 150,000-member investment community help you make better investing decisions.
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