A couple months ago, admitting you had a great balance sheet was like admitting you enjoyed clubbing baby seals. OK, I'm exaggerating, but in the not-so-distant golden days of leverage -- leveraged buyouts, leveraged share buybacks, and highly leveraged hedge funds -- maintaining a simple and strong balance sheet became almost a lost art. However, as the credit markets falter, we should all remember that most great companies don't need leverage to thrive. In fact, strong companies can use healthy balance sheets as competitive advantages.

Pulling the wrong levers
In the short term, leverage seemingly works magic on a company's financial results. For example, if a company earns a 1% return on assets (ROA) and has a 3-to-1 asset to equity (a measure of leverage) ratio, it'll earn a 3% ROE. This company could "improve" its financial results by simply holding $4 worth of assets for every $1 in equity. If the ROA stays constant, then the company's ROE will "improve" to 4%.

However, a higher leverage ratio implies a smaller margin for errors. After all, leverage magnifies both gains and losses. With the benefit of hindsight, we now see that the dazzling return-on-equity ratios many mortgage lenders posted were largely juiced by leverage. In the short run, those lenders fortunes' skyrocketed, and all was fine and dandy. In the long run, some unfortunate lenders that used too much leverage have wilted due in the current credit shock.

As Buffett once remarked, "You only find out who's swimming naked when the tide goes out." Companies that need to pull the leverage lever should be avoided.

Wait, there's more!
Great balance sheets also offer other positive benefits. Having a great balance sheet means that, in turbulent times, a company can capitalize on opportunities that others can't.

For instance, thanks to the housing downturn, many homebuilders now find themselves overleveraged and straining to offload inventory to pay off debt. Motley Fool Hidden Gems selection MDC (NYSE:MDC) holds $670 million in cash versus $1 billion in long-term debt -- a cash position much stronger than nearly all of its homebuilding peers. On the flip side of the balance-sheet coin, competitor Centex (NYSE:CTX) has a whopping $3.3 billion in long-term debt, versus roughly $230 million in cash. While most other homebuilders are trying to shed land inventory to pay off debt, MDC waits patiently until prices get cheap enough to scoop up some bargains.

Recently, Bank of America (NYSE:BAC) took advantage of its financial strength to make an investment in troubled Countrywide Financial (NYSE:CFC). As happened here, relative financial strength allowed B of A to make a bold move during distressed times.

Sometimes, companies can use great balance sheets to win wars of attrition. The auto-parts industry recently endured a severe shakeout. Commodity prices skyrocketed and production faltered at domestic auto manufacturers General Motors (NYSE:GM) and Ford (NYSE:F), helping to push suppliers such as Delphi and Collins and Aikman into bankruptcy. In contrast, a supplier like Johnson Controls (NYSE:JCI), which employs a relatively conservative amount of debt, is in a good position to capture market share from financially weaker competitors.

Remember, the term "great balance sheet" should be defined according to a company's industry. Homebuilders, banks, and retailers, for example, all have different cash flow characteristics, and they don't make for apples-to-apples comparisons.

Fool's final thought
To cap it off, I think the points above can be summarized as follows:

  • If a company has to use aggressive leverage relative to its peers to earn satisfactory returns on equity, it might be time to start looking elsewhere.
  • Instead, look for companies that can outperform by using a conservative balance sheet.
  • Great balance sheets are a competitive advantage; you'll be thankful for it when you need it most.

For related Foolishness:

Bank of America is an Income Investor selection. MDC is a Motley Fool Hidden Gems recommendation. Try any one of our investing services free for 30 days.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.