FOOL ON THE HILL: An Investment Opinion
Beware the Bloated Balance Sheet

While the majority of news media and investors put their attention on companies' earnings statements, the Foolish investor knows that the balance sheet holds the key to a company's financial position. Since earnings are an accounting construct, they usually do not hold all of the keys of a company's true performance. There are plenty of companies out there with growing markets and big profits that are quite unhealthy due to poor conversion of these sales into cash.

By Bill Mann (TMF Otter)
August 16, 2000

Accounts receivable and inventories are the carbohydrates of the financial balance sheet. Sure, they count as assets, but does that mean they're actually good? Just like overloading on carbohydrates is a net negative for anyone not prepared to burn them off immediately, a company displaying higher and higher levels of receivables and inventory can be doing something that seems really good, because they're assets, right? But having a receivable and inventory heavy current asset statement can cause the corporate version of a heart attack -- the liquidity crunch.

So many investors do not understand this. As a result, when Fools criticize companies with increasing sales, increasing earnings, gee-whiz technology, or some other positive attribute, we sometimes take it on the chin from shareholders who either cannot or do not want to grasp the importance of a healthy balance sheet. But a company that has ample growth in sales that does not convert those sales into cash on a fast enough basis can essentially grow itself out of business.

That's right, a company that does not manage its cash position, even if it shows fast growth and exceptional profit margins, could find itself in a liquidity crunch that provides a real threat to its shareholders and its very survival. This is precisely the reason that the Motley Fool's Foolish Flow Ratio treats inventory and accounts receivable as liabilities, and accounts payable as assets. To be owed a lot of money is a fine thing, but you've got to be able to collect this money in order to stay in business.

Balance sheet topics are often about as exciting as reading the phone book, so let's try to put our Hollywood spin on the subject to create a little buzz about inventories and receivables, eh? Our company, Bobdog Creative E-doilies (Ticker: LACE) has one of the true visionaries in e-doilies at the helm, has "strong buys" from all of the big financial houses, and a product that generates a level of excitement in consumers unknown since A.H Reese decided to combine chocolate and peanut butter.

But deep under the surface Bobdog is treading on quicksand. Because Bobdog's visionary leader, recently picked as one of People's Most Eligible Bachelors, his board, and management team are so focused upon top-line growth that they cannot be bothered with trivial things like collecting on sales. As a result, even though Bobdog's net profits increased by 50% from the previous quarter, it's getting awfully close to being sucked under.

Here's what (a grossly simplified version of) the current portion of Bobdog's balance sheet looks like:

(In thousands $)

    Cash & Equivalents             832
    Accounts Receivable           3131
    Inventory                     4388

    Accounts Payable              1517
    Other Current Liabilities     1213
This balance sheet tells us that Bobdog E-doilies has working capital (Current Assets - Current Liabilities) of $5.6 million and a current ratio (Assets / Liabilities) of 3.06. On a cursory level, Bobdog's rocking the house. But add these assumptions in to the mix:

1) Bobdog's liability payment terms are 30 days;
2) Bobdog's receivables average payment in 75 days;
3) Bobdog's inventory levels do not change as a function of sales.

Under the above assumptions, Bobdog E-doilies could not operate for long absent external sources of cash. The company has a good product (I mean, who wouldn't want a Bobdog e-doily?), expanding sales, and large operating profits. But since accounting works on an accrual method, the income sheet does not show a glaring weakness: the fact that the company is incapable of collecting cash in a timely fashion means that the vast majority of its current assets are not in their most liquid form: cash. And worse, the more the company grows, the worse its cash position becomes; its bills are coming in faster than its cash. Quicksand.

This is very, very important for investors to understand. All too often we see a focus upon profits or losses, with companies getting run up or down the flagpole based on their income statements. But the income statement is little more than an accounting construct. There are some really useful things that one can glean from the income statement, but non-cash factors like depreciation and amortization have a way of hiding how a company actually performed. That's much more difficult to do on the balance sheet, which shows companies' financial condition, a concept equally as important as profitability. A company can be "unprofitable" and still be in great financial shape. A company in poor financial standing, however, has got problems.

There is a certain logic involved in balance sheet reporting of assets. The higher on the list an asset appears, the more liquid it is. "Liquidity" in this case refers to how quick something can be turned into cash. Not surprising, then, that cash is at the top of the list. Receivables, while they can usually be converted into cash fairly quickly, do not have the same level of liquidity as greenbacks or investments. Inventory, which must be sold, thus generating a receivable, is less so. So, though these are assets, their lack of immediate liquidity makes them less valuable from an operating basis. Under most circumstances you may not pay a bill with assets. While a big list of current assets is nice, creditors require cash.

So what happens when a company has a liquidity crunch? Bad things, as far as an investor is concerned. Management pundit Peter Drucker once noted that a company that has a profit crunch is often forced to sell off its least profitable components, while a company in a liquidity crunch must sell its most profitable components.

Perhaps investors should look at it this way: If you hold a company that is running out of cash (or equivalents), regardless of sales growth, profitability or other indicators, there are only a few ways the company can pay its bills. It could sell a component for cash, thus erasing one of the rationales for buying its stock in the first place. It could issue debt, which would be acceptable for capital expenses but is not a great sign for operating liquidity. The company could raise cash through additional equity offerings, diluting your share value. Or it could just not pay its bills, which its creditors would not appreciate from a company with a poor cash position. All of these eventualities spell trouble, when they are caused by cash shortfalls as opposed to capital development.

In the recent past, several Fools have been quite critical of Lucent (NYSE: LU). This is a company with everything going for it: a growth market, excellent product lines, enormous sales, and yet its cash position has been consistently horrendous. Lucent has forsaken its cash position to the benefit of its gross sales numbers. As long as Lucent does not take care to manage its cash conversion cycles through inventory reduction and accelerated collections, it will not reach its full potential. The prudent investor needs to look a bit deeper to ensure that the company is collecting the money for these sales in an accelerated manner. Lucent is at no risk of growing itself out of business, but it is in real danger of underperforming due to poor financial standing.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Related Links:
  • Rule Maker report, 6/27/00: Current Assets on the Balance Sheet
  • Rule Maker Criteria: The Flow Ratio