A company's balance sheet is something investors might not think about much until trouble comes along -- then, it can be a lifesaver. For growth investors, a strong balance sheet means a young business can survive recessions or avoid selling new shares to raise money. For income investors, a company can keep paying and raising its dividend to shareholders year after year.
Fortresses go back hundreds of years -- they're robust castles and buildings designed to keep invaders out. Today, you might hear a company with solid financials referred to as having a fortress-like balance sheet, a seemingly impenetrable defense that protects investors' money from harm.
Stocks are not created equal, and finding companies with fortress-like balance sheets can help you sleep well at night and keep your portfolio on track. Don't worry; if you're unsure what to look for, I'll show you below.
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What growth investors should look for
Growth stocks are typically younger companies and in many cases, not yet profitable. Growing companies may avoid debt altogether, instead selling stock to raise money if needed. In that case, a substantial balance sheet funds the company's growth until it (hopefully) turns a profit down the road. Selling too much stock to raise money reduces the value of existing shares, because they represent a smaller ownership stake in the company (this is called dilution).
You want to follow the company's free cash flow, which is the cash it generates above and beyond any spending on capital expenditures, or its investments in future growth. In a bear market like 2022, cash-flow struggles can force a company to raise funds by selling a ton of new stock at low share prices (or issuing debt at unfavorable interest rates). Ideally, a company would sell stock when the share price is high to raise cash without heavily diluting investors.
Pay attention to how much free cash flow a company burns through each quarter and compare that to the cash and short-term investments the company has on its balance sheet. Company ABC with $3 billion in cash on hand that's only losing $100 million in cash each quarter is in a much stronger position than Company XYZ with $3 billion in cash that loses $800 million each quarter. Companies strive to become profitable over time, so see if cash losses increase or decrease as revenue grows. A company losing more cash as it grows larger is a potential red flag.
What dividend investors should look for
Dividend stocks are a different ball game since companies paying dividends are already profitable and likely more mature (reporting slower growth). In this case, the balance sheet becomes more flexible; most dividend-paying companies carry debt on their balance sheet to some degree.
The first thing you'll want to check is the company's leverage or how much debt it has compared to how much money it makes. You can check the ratio of a company's long-term debt to its EBITDA, for example. This comparison of the company's borrowings to its core earnings (before most accounting adjustments) shouldn't climb too high. As a general rule, I would begin to worry if that ratio exceeds 3. However, you can set your own rules based on what you're comfortable with and the sector in question.
Investing in dividend stocks means you want reliable income, so you can look for balance sheet clues to signal whether the dividend is safe. Look at the dividend-payout ratio to determine how much of a company's profits are going to the dividend. For example, suppose a company pays out 90% of its earnings as dividends. In that case, there isn't much financial breathing room for the company to spend money elsewhere or to handle a downturn in the business. A payout ratio below 70% is ideal for most types of companies.
Lastly, you want to see what a company spends its cash profits on. Dividends and share repurchases are common ways to return value to shareholders, but they can also be red flags if a company borrows money to do so. Look at a company's financial statements to ensure that its dividends paid and share repurchases don't consistently add up to more than the company's free cash flow.
