"Is she tight?"
For some reason, in the fatigue of a late spring morning after a grueling tax season, my mind hung on the word, which is, among other things, slang for "tipsy." The question inexplicably summoned up the image of a renegade ship from one of those half-forgotten childhood adventure novels, complete with pirates in a scramble up the rigging, cursing mightily as they trimmed the sails in a fierce wind.
"Yes, sir, she's tight."
Henry, one of the partners in the staid, decades-old CPA firm where I worked, was of course referring to the audit, in the form of two bulging, string-bound manila folders that I had just placed on his desk for review. This was the early 2000s, in the twilight of paper-based audits, before everything went electronic. I was a junior auditor in my third year, and had recently graduated from working on senior staff members' audits to heading up my own very small ones.
I knew what "tight" meant. It meant that you had cleaned up all the loose ends in your field work, that your numerical schedules footed (summed) perfectly, that you had run a well thought out set of analytical procedures to uncover any glaring signs of fraud or incompetence. It meant a thousand small things. But it was also related to a more mysterious question Henry often posed, which true to form on this morning immediately followed:
"Does the balance sheet tie out?"
When you tied out the balance sheet, you used source documents to verify that the ending balances of the asset, liability, and equity items on a company's books were correct. If a particular account was off, you made proposed adjustments to square it away.
I was good at tying out a balance sheet, but I wasn't quite sure why it was so important, other than it made a company's books accurate.
And I was a bit shy of asking the question. While Henry was one of the most accessible partners in the company, he was also a master of his accounting universe. Audit partners from larger firms all across the state called him for advice when they were up for credentialed peer review.
Despite his patient demeanor, and eyes that brimmed with mirth whenever he listened to you, I was a bit overawed of my mentor. And until that point, I had regrettably little experience outside of the classroom in speaking up and pushing to satisfy my curiosity. At times, learning is like using an old Zippo lighter -- easy enough in principle but you still have to tease the flint wheel a few times before illumination bursts through.
Eleven words, an unanticipated leap
A few weeks went by. I strode into Henry's office with a faintly visible touch of swagger and stacked three shipshape folders on the corner of his expansive oak desk. This one had me feeling righteous.
I knew it was tight, and more importantly, I had achieved the "warm fuzzy," a term auditors, chained to Excel schedules but imagining themselves to be hipsters, use when describing a gut sense that a company's financials are fairly stated. Above all, the warm fuzzy is just what it implies: a glowing rush of confidence that you can stand with conviction behind your "clean opinion" on the financial statements you've audited.
After answering the two expected questions in the affirmative, my curiosity that morning trumped my deference. "Hey, by the way," I managed, "why is it so important for the balance sheet to tie out?"
The audit partner's PaperMate Flair pen froze an inch above a legal-sized ledger sheet. The page was a scrim of his assertive handwriting in felt-tipped green ink. With an eye-blink glance, I saw that he was up to the 17th review point on the audit of a colleague even fresher than myself.
Henry looked directly into my eyes with the matter-of-fact poise of someone about to state a fundamental law of nature.
"When you tie out the balance sheet, the P&L falls out."
Perhaps you've had an epiphany in your professional career that influenced nearly all of your subsequent work. Those eleven words opened up a line of sight for me, not just as an auditor but also later on as an investor. Here's another way to express the same thought: When you square away the balance sheet, the true narrative of the P&L (statement of profit and loss) is exposed.
Divining the oracle
To illustrate what Henry meant, suppose you're auditing a company that posted $6 million in revenue during the year, and from this top line, netted $400,000 in profit. One of your tasks will be to "tie out" accounts receivable on the balance sheet to determine if what the company says it's owed by its customers at year-end is correct.
In analyzing the schedule of receivables, you find that $500,000 worth of invoices are extremely old. They're from the first quarter of the year, and worse, issued to a customer that went bankrupt in the second quarter.
After discussion with the company's finance personnel, it's agreed that the monies are quite unlikely to ever be collected, and the entire amount needs to be written off.
You make the adjustments and rather than a $400,000 profit, the company's financial statements now reflect a $100,000 loss. You've arrived, without bias, at the truth of the matter: In tying out the balance sheet, the P&L has fallen out.*
In the months that followed, I started to see the balance sheet not as a dry listing of assets, obligations, and equity but as a living snapshot of the relative health of a company.
I left the firm a few years later, but throughout my financial career, this single insight -- to understand a company's resources first before looking at its profits and losses -- has helped me find a level of clarity in finance I might never have had, despite uncounted hours in the field.
And it's helped my investing immeasurably. As you can likely guess, the one thing I always do before I buy a stock is to read the balance sheet first. Doing so fills in a reservoir of context when I'm making an investment decision and prepares my brain for a deeper understanding of a company's present and future earnings. To be balance-sheet oriented is to be free of certain crutches and insecurities held by the investor who only looks at the P&L.
Start orienting yourself today: it's easier than you may think
You don't have to be a finance professional to know how to read through a company's resources and obligations to your advantage. Here are four starter questions -- actually, big-picture curiosities -- that I often ask myself when scanning a balance sheet. You can ask similar broad questions before committing your own capital to a publicly traded company. If you'd like to delve into this further, I've written a companion piece that treats these questions in more detail, but here they are, with brief explanations:
- How deep is liquidity?
Does the company have enough of current assets on hand to meet near-term obligations?
- What about solvency?
Solvency is a measure of a company's ability to pay its long-term debts. How heavily is the business leveraged, and why?
- Does the company's capitalization make sense versus its game plan?
Is the company capitalized, or funded, primarily by equity, debt, or prior-year profits in the form of cash and other assets? How does this square with the business strategy management has put forward -- will the balance sheet realistically support the plan, or not?
- How have major assets and liabilities changed from period to period?
The SEC requires public companies to present balance sheets against comparable prior periods. There's almost always a story that leaps out once you compare two or more periods of assets, liabilities, and equity; look for the trends that form the narrative.
Bear with me a moment more as I hook up an intravenous unit to an aged metaphor. Imagine that you're about to take a journey to another continent via an ocean crossing. You walk into the harbor and see the captain pacing by the water's edge. He's young but seasoned, having navigated through all types of conditions, and is renowned for his easy command and imperturbable demeanor.
Then you spy the ship. It's in a sorry shape, mottled and worn, with sails like blue jeans patched at the knees, and a mast that shows signs of serial repair. Ready to stow your belongings and move below deck for the start of this transatlantic journey?
The captain, of course, with his ability to capitalize on the wind and steer the vessel, represents the P&L. The ship is the balance sheet. You need both to be in reasonable shape. Without proper resources or the means to obtain them, even the best business opportunities are doomed.
So before you buy your next stock, try the following. Go to Fool.com and type in your prospective investment's stock symbol in the "ticker or keyword" box placed in the top right corner of home page. When you arrive at the company page, scroll down, and on the left hand side, hit "Balance Sheet" under the "Financials" section.
Now look around and inspect the rigging. Ask yourself: "Is she tight?"
*Accounting mavens, I've simplified this example without regard for any contra/allowance balances to accounts receivable that might have existed, which would represent past expense incurred in anticipation of a bad debt event like this.