Balance Sheet Breakdown: Separating the Strong From the Weak

What separates a strong balance sheet from a weak one? In this podcast, Motley Fool senior analysts John Rotonti and Bill Mann discuss:

• Assets, liabilities, and when more liabilities can actually be a good thing.
• A surprising way one retailer generates cash from its balance sheet.
• Companies holding the most formidable cash piles in the world.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on April 23, 2022.

John Rotonti: But because they have so much scale and so much negotiating leverage, they don't pay their vendors for four or six weeks. They're selling it in four or six days. They don't pay their vendors for four or six weeks. They have six weeks of free financing from their vendors. Their vendors are financing the organic growth of the business. It's truly fantastic.

Chris Hill: I'm Chris Hill and that was Motley Fool Senior Analyst John Rotonti. On this Saturday classroom, he talks with fellow analyst Bill Mann about a retailer using its balance sheet to generate extra cash for shareholders. Together, John and Bill are separating the formidable from the weak and giving you some ideas for companies with a sneaky strong composition.

John Rotonti: Hi Fools. I'm John Rotonti and I'm joined by my buddy Bill Mann. Hello, my friend.

Bill Mann: We're getting the band back together. How are you, brother?

John Rotonti: I'm doing great. Nothing I enjoy more than doing some video or audio with you. Fools today we are talking about the balance sheet again. We did a prior Motley Fool Money episode on the balance sheet discussing what is a balance sheet, how to interpret and analyze the balance sheet, and how the balance sheet connects to the other primary financial statements. But the balance sheet is so important. We want to do a follow-up episode where we give you some examples of companies that we think have a sneaky, strong balance sheet, and a less strong or possibly even weak balance sheet. The reason the balance sheet is so important Fools is because the balance sheet is where the search for a resilient business really starts and ends. If the business doesn't pass this first filter then personally, my research stops and I move on. Why? Because the balance sheet is the structural foundation of a business. History shows that a sustainable and resilient business cannot be built a top of weak foundation. Think of a house, a building, or any other physical structure. The future survival and sustainability of that structure is at risk if it is built on top of a weak foundation, so with that Bill, let's start off with an example of a company that you think has a strong balance sheet. What you got?

Bill Mann: One of the most fortress like balance sheets that I know of his Costco (COST -0.13%). Costco currently has about $11 billion in cash and short-term investments. They have incredible working capital characteristics. It is a company that carries a fair amount of debt, about $6 billion in debt, primarily because they use their cash flows to buy the land for the most of their warehouses are built upon. So it's a company that is not without debt. I think a lot of people, when we talk about strong balance sheets, they think immediately like, "Oh, I a want balance sheet that has 0 debt on it." That is a way of making a balance sheet bulletproof, if you will. But Costco has an adequately levered balance sheet.

John Rotonti: I agree completely. I think we both own Costco, and the point that I really want to drill down on is, as you said, that it has this amazing working capital management. Costco actually makes money off its balance sheet because [laughs] it has a negative cash conversion cycle, it has negative working capital. Because what happens is, as you know, they buy merchandise and inventory from their suppliers. They put that inventory on the shelves in the store and then they sell that inventory within five or six days. But because they have so much scale and so much negotiating leverage, they don't pay their vendors for four or six weeks. So they're selling it in for six days. They don't pay their vendors for four or six weeks. They have six weeks of free financing from their vendors. Their vendors are financing the organic growth of the business. It's truly fantastic.

Bill Mann: A vendor would do that in a second with a company like Costco because they know very well that Costco is going to pay it's bills because once again, the reflexivity of that balance sheet, they know full well that Costco's financial structure is such that they do not have to worry about receiving that money, because Costco tends to go and buy such huge amounts from their suppliers. They become a structurally important company for those suppliers. So the suppliers, you don't want to say that they are happy to wait. All of us would rather have our money paid today than 60 days from now. But they are completely satisfied with that model with Costco. Costco is actually making money with its balance sheet. It's a very rare company that is in that position.

John Rotonti: It is very rare. For my strong balance sheet example, I'm going to go with the obvious, which is Alphabet (GOOG -2.05%) (GOOGL -1.98%). I think Alphabet has possibly one of the, if not the strongest balance sheets in the world, here's why. Alphabet has a $139.6 billion in cash and only 28.5 billion in total debt. That includes all their leases. It has net cash of 111 billion. It gets better.

Bill Mann: It's a lot.

John Rotonti: Net cash Fools just means more cash than debt. It has 111 billion more in cash than debt. It has 359 billion in total assets on its balance sheet. It's net cash makes up 31 percent of its total assets. This is a super cash-rich balance sheet. It's market capitalization, or market value is 1.72 trillion. So it's net cash makes up about 6.5 percent of its market value. To quickly put Alphabet's balance sheet into perspective. Apple also has a massively cash-rich balance sheet. But Apple is working very hard, actually, believe it or not, to get down to net cash-neutral. So Apple has 80 billion in net cash against 381 billion in total assets. Apple's net cash as a percent of total assets is 21 percent. That is still very, very strong. But remember, Alphabet's net cash as a percent of total assets is 31 percent.

Bill Mann: I'm going to say something as if there are several of these but they really are very few, but when you see a company like Alphabet with a $111 billion of cash on its balance sheet. Obviously that is some security blanket and it allows them in some ways. This will seem a little counter-intuitive to make mistakes, to go out and take risks that do not put their core business or shareholders at great risk at all. But when do you see that much cash on the balance sheet do you not think in some ways that that is a sign of insecurity for the company.

John Rotonti: It could be. I love this question. Yes, I think that net cash of 111 billion allows the company to have a security blanket like you talked about, which allows us to play defense. Then a large net cash position like this also provides optionality and allows a company to play offense by investing heavily in down-markets when asset prices are distressed. In Alphabet's case, it spends so much money on long-term investments in the form of CapEx and R&D. That in Alphabet's case, I don't think it's a sign of in securities. I just think it's a sign that they're generating more free cash flow than they possibly know what to do with. So just to put some numbers around that. In 2021, Alphabet spent $31.6 billion in research and development one year 31.6 billion in research and development. Alphabet spent in 2021 24.6 Billion in CapEx.

John Rotonti: In one year it's spending $30, $40, $50, almost $60 billion between R&D in CapEX in one year.

Bill Mann: Which is a weapon that they have, that few companies have ever had. What you're talking about here John is something that we as analysts called the sources and uses of capital. One of the incredible things about Alphabet is that their source of capital is the single greatest source you can have. They haven't gone out and raised equity, it's their cash flows that they are generating that cash from, and that's what they are using to fund any number of research, development, arms, any type of their capital expenditures, all generally funded from cash from operations.

John Rotonti: That's exactly right, and so I said $60 billion in total investments, it's $56 billion in total investments.

Bill Mann: You were exaggerating a little? That's fine, that's great. We're all about honestly.

John Rotonti: A little bit. Fifty-six billion in one-year Bill, in one year, 56 billion in long-term investments. Yet they generated in cash flow from operations, $91.6 billion in cash flow from operations. So if you take $91.6 billion and subtract that from $56, do that with your hand fingers and toes for me, Bill. That's $35.6 billion in free cash flow in one year, $35.6 billion, so yes. Then the last thing I'll say about Alphabet is their interest coverage ratio which is their operating income or EBIT, as a numerator divided by interest expense, is 227, which means that one year of Alphabet's operating income could pay 227 years worth of its annual interest expense. That's why I picked Alphabet for my strong balance sheet category. What do you have Bill, for your sneaky strong?

Bill Mann: I have company that has, as of its last annual report, $236 billion in total liabilities.

John Rotonti: Let me wrap my head around that, $236 billion in total liabilities?

Bill Mann: Which means that if you were the only shareholder of Ford, you would have $236 billion in liabilities.

John Rotonti: Wow. Remember Ford's liabilities were on the balance sheet, remember that balance sheet assets equals liabilities plus shareholders equity.

Bill Mann: Yeah. Which is barely more or less, that is $267 billion in assets at this point. This is Ford, is an incredibly levered looking company. It looks incredibly levered, but the really important thing to note about Ford is that an extraordinary component of its liabilities come in the form of Ford Credit. It's the credit that they both provide and own for financing Ford vehicles through dealerships around the country and around the world. In a lot of ways, it is a pass-through for them and a profit center for them, but they still do have to carry that, they still do have to carry those liabilities on their balance sheet, and they look massive.

John Rotonti: It's so weird with banks. I love that you brought up Ford, because with banks, which is what we're talking about here.

Bill Mann: It is, that's right. It's so great you made that point, because Ford is a bank that also happens to sell.

John Rotonti: This is their financing, and so with banks debt it's an inventory, because you use the debt to give out loans which are assets, and so it's weird, you really have to bend your mind to think about debt at a bank. You can't think about debt at a bank in the same way you'd think about debt at an industrial company or something like that.

Bill Mann: Right. Which is exactly why, when you think about Ford, or you can think about any company that has a large financing arm, and Ford's financing arm is indeed massive. You really need to flip that switch and think of it as being a bank that also happens to do other things.

John Rotonti: I love that. Charlie Munger says, "Invert, always invert," and so think about it in that way. My sneaky strong balance sheet is Lowe's, the second largest home improvement retailer in the world. Lowe's has a market value or market cap of a $134 billion, but it only has $1.5 billion in cash against roughly $29.4 billion in total debt, that includes leases. That's very large net debt position of nearly $28 billion. At first glance, it looks like a less strong balance sheet, but then you dig beneath the surface Bill, and you see that it has zero variable rate debt, and zero bank debt. It's all corporate debt, it has zero commercial paper outstanding, and it has not yet taped its revolving credit facility, so that's completely untapped. As far as maturity is on its debt, less than 3 percent of its debt and leases mature in the next year, and 84 percent of its debt is not due for five years out or longer. It has a triple B plus credit rating, from S&P Global, which is an investment-grade rating. Also, it's interest coverage, remember we defined that as EBIT in the numerator or operating income in the numerator, divided by interest expense. It's interest coverage is 14 times, which means one-year of its operating income can pay 14 years worth of annual interest expense. But here's where it gets better, it's EBIT to interest expense of 14 is the highest it has been since 2009, so it's interest coverage is the highest it has been in 13 years, so things are definitely trending up at Lowe's. Then finally, Lowe's sells products and services that are relevant and in demand and that serve a crucial economic need, so the business is fairly reliable, its cash flows are fairly reliable and predictable and it generates really high returns on invested capital and free cash flow, and it uses that free cash flow to service that debt.

Bill Mann: I don't have the number right in front of me, but there is something that's really important about balance sheets, particularly with companies that do have debt and do have lease-hold obligations. Lowe's maybe fits this really well. Almost none of Lowe's business is in the form of really large, single customers.

John Rotonti: Yeah. It's split between buying a bunch of modern pops.

Bill Mann: Plenty of wholesale, they do plenty of wholesale.

John Rotonti: It's 25 percent of its business is professional contract.

Bill Mann: But of that 20 percent, there are no super professional contractors that make up 15 percent of it. They don't have some sneaky obligation or some sneaky risk, because although it feels great for companies to have huge customers, you don't necessarily want that in conjunction with debt and lease hold expenses,.

John Rotonti: Exactly 100 percent. Our third category, Fools, less strong balance sheet, borderline week. Which you got for us?

Bill Mann: We're going to talk about a hot mess.

John Rotonti: What you got?

Bill Mann: Rite Aid.

John Rotonti: I haven't looked at that one but it doesn't sound like a strong balance sheet.

Bill Mann: Yeah, wrong aid, first aid, Rite Aid. Rite Aid is a company that went bankrupt and had to be reorganized a number of different times in the 1990s, and 2000s. I want to say that they're on Chapter 11 times three or four so Chapter 44, maybe at this point, a lot of chapters in the righted bankruptcy book. But they made a choice a number of years ago to again try and grow their business. They borrowed heavily, and so they've got about $3.2 billion in total debt and they have to service that debt and you service that debt through cash. Not through earnings through cash. You must actually pay in hard cold dollars. Their expansion has not gone very well. Over the next year, they have to pay something on the order of $300 million to service their debt and they may not hit that amount in terms of number that we make fun of a little bit, but it is a good number. Their earnings before appreciation, their EBITDA number. They may not have enough cash to service that debt. Rite Aid has painted itself into a corner, and it really has to operate. Otherwise, we may be adding 11 chapters toward bankruptcy book.

John Rotonti: Yes. What does it do if it can't come up with the EBITDA than it either has to, like you said, borrow more [inaudible] debt.

Bill Mann: What terms are they going to get for that job?

John Rotonti: Those are going to be used for it. [laughs]. Those are not going to be good terms or then maybe they go into some distressed down the road again. Yes, Rite Aid does not sound like a particularly strong balance sheet. Thanks for bringing that one. I'll close it out with my less strong balance sheet idea. I'm going with Norwegian Cruise Line. This balance sheet is just too risky for me personally. I understand that mask mandates are being removed and people are shifting their spending toward experiences and travel after sheltering for the last two years. So it's finances should actually improve going forward. I understand all that. But Norwegian has $1.75 billion in cash against $13 billion in total debt. It's net debt is $11.4 billion. But get this. It has net debt, it has $11.4 billion more in debt than it has in cash. But its market cap is only 9.3 billion. This company, Norwegian Cruise Lines, has 2 billion more dollars in debt than it has in market value. I can't give you it's interest coverage. It's eBIT divided by interest expense. Because it currently does not generate any eBIT. [laughs].

Bill Mann: It's not that you don't have the number[laughs].

John Rotonti: It's not meaningful. It comes up as non-meaningful.

Bill Mann: It's meaningful.

John Rotonti: Even before COVID though, if we go back before COVID and before lock-downs, its interest coverage was somewhere between 4 and 4.8, so less than five. It's interest coverage was less than five even before COVID. The Altman Z-score is a metric that predicts the likelihood of bankruptcy. It's an amalgamation of several different financial health ratios and leverage ratios and coverage ratios and it adds them all up and it comes up with the score. It's called the Altman Z-score, and it predicts the likelihood of financial distress down the road. The rating system for the Altman Z-score, anything below 1.8 is considered as risky territory. When Norwegian's Altman Z-score is currently negative 0.44 because remember it's not currently generating any earnings or free cash flow. Or even it doesn't even generate operating, right now it's operating cash flow is negative, so it doesn't have any means to service that debt

Bill Mann: Some of that is a little bit tricky because obviously and you started with us, so this is fair. Cruise liners were deeply impacted by the pandemic. But here's where and I want to make sure that people understand what you are saying because you are not saying Norwegian Cruise Lines is doomed, what you are saying is that they have had to make some real, really hard financial decisions to get to where they are now. You can look, for example, at the cash flow statement and you can see that their capital expenditure is dropped by about half between 2019 to 2021. Some of the things that they have done were to put off things like maintenance, to put off some of the capital expenditures that they need to continually spend to keep a good cruise line up and running. They've issued a lot of capital stock, a lot of dilution, and all of this flows back to the balance sheet for a company that does not have the E at this point in time. They did what they had to do to survive. I mean, that's fair.

John Rotonti: It's fair they were in survival mode. There are investors, great investors, for example, Bill Miller is currently invested in the cruise lines. I don't know if he's in new region, but he has talked about how he thinks the cruise lines could be a great turnaround story. There are great investors that see opportunity here, great investors. But how I started this segment, I said, Norwegian is too risky for me, for my blood. This is just not the type of investment I personally feel comfortable making. I do think that their finances and the outlook for the business will improve going forward.

Bill Mann: Thousands of companies out there and this is just not one that you are.

John Rotonti: For me.

Bill Mann: Fair enough. That is what makes a market.

John Rotonti: Is too weak for me. There you have it Fools Bill Mann and myself, we just gave you six companies two, that we think have a strong balance sheet. Two, that we think have a sneaky strong balance sheet.

Bill Mann: That's four strong balance sheets.

John Rotonti: That's four.

Bill Mann: I'm adding up.

John Rotonti: Yes. Then two that have lesser strong balance sheet borderline week, Bill, we should do this more often.

Bill Mann: Anytime you want my friend, great to spend this time with you. [MUSIC].

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.