The fierce economic headwinds currently pushing against your companies include dysfunctional credit markets, continued deleveraging, a banking crisis, and a severe recession. Now more than ever, investors must be mindful of companies' financial strength.
This takes us to the balance sheet. It is critical that companies you invest in right now have significant cash positions, low debt, no debt, or ensured access to credit in order to ride out this crisis. In a recession it's all about preservation of capital. You're not looking for companies that can necessarily profit in the downturn; rather, look for companies that can preserve capital and better reposition themselves for the coming boom.
Testing financial strength
There are a number of ways to test balance sheet strength. The first is cash. Cash is always king, and now, as far as investors are concerned, cash is the messiah.
You can check how much cash a company has in its coffers by looking at how much cash is on the balance sheet. Look to see if the company has increased its cash position since last year. You can also measure a company's health by calculating its current ratio (current assets/current liabilities), which measures the company's ability to pay off its short-term obligations. A current ratio of 1 means the company has just enough short-term assets to pay off its short-term liabilities; higher ratios mean that some current assets would be left over, which is better.
Another way to view a company's cash position is to look at cash per share. This shouldn't be looked at in isolation, because it's a dynamic number, and the company could be burning through the cash instead of generating more. To help with that, also look for trends in cash flow. For instance, is cash flow from operations accelerating over a multiyear time period? The answer should be "yes."
The next point of examination is the amount of debt the company carries on its books. There are a number of ways to measure this; the most common is the long-term debt-to-equity ratio. A ratio of 1 would mean that the company's creditors finance $1 for every $1 of equity the stockholders give. In this environment, the lower the ratio, the better, as refinancing can be painfully expensive and can increase default rates.
With these guidelines in mind, I sought to uncover companies with strong balance sheets by running a screen using the Motley Fool's CAPS screening tool. I searched for companies with:
- Current ratios of 1 or greater.
- Long-term debt-to-equity ratios of 1 or less.
- CAPS ratings of five stars, the highest.
- Market caps of $250 million or greater.
Here's what popped up on my screen when I ran it:
|
Company |
Market Cap (in billions) |
LT Debt-to-Equity Ratio |
Current Ratio |
|---|---|---|---|
|
Bristol-Myers Squibb (NYSE:BMY) |
$41.4 |
0.49 |
2.3 |
|
China Mobile |
$201.2 |
0.08 |
1.3 |
|
EMC (NYSE:EMC) |
$27.2 |
0.22 |
2.2 |
|
Fluor (NYSE:FLR) |
$9.4 |
0.05 |
1.5 |
|
Johnson & Johnson (NYSE:JNJ) |
$155.1 |
0.18 |
1.6 |
|
Lufkin Industries |
$0.6 |
0.01 |
4.0 |
|
Morningstar |
$1.9 |
0.0 |
2.2 |
|
Royal Dutch Shell (NYSE:RDS-A) |
$88.4 |
0.11 |
1.1 |
|
Sigma Designs (NASDAQ:SIGM) |
$0.4 |
0.0 |
9.2 |
|
Transocean (NYSE:RIG) |
$24.4 |
0.82 |
2.0 |
Data from Motley Fool CAPS.
Balance sheet strength is a critical element to look at when researching companies. However, it's only one factor. Investors must remain mindful of the industry in which the company operates and whether that industry has growth potential. From there you must assess what the company's position is within the industry. Is it a leader? If not, does it have a product or service that is gaining traction in the market to gain market share? These are just some of the questions to ask.
Start finding the strongest companies for your portfolio at Motley Fool CAPS today! Let the collective wisdom of our 135,000-member investment community help you make better investing decisions.
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