What should you watch for when analyzing the balance sheet?

Over the course of the past few weeks we have been talking about various asset classes and how to go about investing in them. Perhaps the backbone or the central theme of any investing lies in how you analyze a company or the worth of a particular asset and then reach a logical conclusion.

To that regard, balance sheet analysis is something that often goes ignored, especially, when you are looking at stocks but its something that is perhaps the central driving force of understanding what makes a company tick. Nikhil Vora, MD of IDFC Securities and Bharat Iyer, Head-India Equity Research at JPMorgan, in an interview with CNBC-TV18�s Mitali Mukherjee break up the workings of a balance sheet and explain how it should be analyzed. Below is a verbatim transcript. For the complete details watch the accompanying video. Q: How would you define what a balance sheet is and what its analysis entails? Vora: The genesis or the core of any investment research lies in how one is able to understand and analyze balance sheets and make a slightly more informed decision making post that. Its important to read the numbers beyond what is published, be it on the revenue growth of businesses and how that�s getting derived, to what are the salience�s of certain balance sheet items, be it on the debt part, be it on receivables and so on. It�s important to judge particular businesses and companies in the context of how their reporting standards are and how transparent and consistent they are in the same as we move forward. Q: For a lot of people who analyze stocks it is a non-sexy item in terms of analyzing the company, it�s easier to work with earnings or ratios rather than read some kind of conclusion? Iyer: I guess while earnings is just one particular number what you want to see is the key drivers and the key pressure points behind the number and it�s very important to look out for these. Reporting a set of numbers given some constraints is always easy but from an analyst perspective we want to see what is driving numbers and what is impacting numbers. For that you need better disclosures and you want to see the background information behind it. Luckily in India, we have fairly well set accounting standards. Earnings are reported almost four times a year every quarter and we also have access to balance sheet and cash flow data at least once in a year. So while you prefer balance sheet and cash flow data more often, I guess even the earnings numbers given to us once a quarter are fairly well defined and we have fairly decent disclosure standards so that does help. Q: To get to the broad heads of a balance sheet that we are looking at, there is assets liabilities, equity of cost but let�s take it with assets. What are the ABC items you would look at while analyzing the asset side of a company? Vora: I think the most critical element of any balance sheet read that one would look at is to look at the size of the balance sheet first level and its important from the construe that one makes about growth of a business whether the balance sheet size also keeps growing in pace with that because the revenue generation capability of any business is dependent on the investments or the asset base that the company has over a period of time and how they build it up. The first level is to look at how the overall fixed asset of the business mold grows and the second part is to look at the constituent of that fixed asset and how that is getting financed out, be it through the net worth of the company or through the debt of the business. To me that�s the two critical elements to look out for. The third part is to look at the receivables in that business because as we move forward whether the business growth is been driven by the underlying cash flow generation capability of the company or it�s been funded by pushing the business through a receivable cycle which can literally lead to debt trap over a period of time that�s the critical element to look at. Q: Aside from the size of a balance sheet does the structure and style of the business matters as well because on your point about cash flows, it makes something like a construction company more vulnerable versus another sector, right? Vora: It does. That�s the reason why you also see in lot of cases how businesses tend to get de-rated or rerated based on how the balance sheet is perceived to move today and forward. A business which has the capability to grow on its own cash flow which would mean that its generating adequate cash reserves and thereby growing on net worth and not on debt does tend to get rerated significantly ahead rather than a business which is growing on external capital at every stage in their growth path. That�s the difference which ideally gets realized very early in life. You start to look at businesses accordingly and the fact that they are a branded business for instance will grow significantly on their own cash generation whereas in a lot of infra businesses that we look at today, it does grow on external capital. Thereby the rerates in those businesses do take a lot more time and a lot more persistence than a branded business or a consumer business would do. Q: What do you watch for while analyzing the balance sheet for company in order to understand the liabilities what do you watch for while analyzing the balance sheet of a company in order to understand the liabilities and more importantly the size of them and the impact on earnings thereof? Iyer: When you are looking at the liabilities, you look at quite a few factors. It�s just not the quantum of liabilities; you are looking at the solvency of the company itself whether the sheer size of the liability in relation to the size of the company�s operations. You are also looking at the liquidity situation of the company. You are looking at the tenure of the debt in particular because what you don�t want as a mismatch between the borrowing side and the asset side, you don�t what long-term borrowings going into short-term assets or visa versa. Besides this, you also look at few factors like the nature of balance sheet items, if the company has indulged in sale and leaseback for example or even the contingent liabilities they tend to be very important because these are very easy to ignore but they do have a material impact on the company�s operations down the line. It�s quite important to take at comprehensive view. Q: Why is it that a lot of people also tend to work with cash flow statement rather than the balance sheet and what would you draw as a defining line between the two? Vora: At lot of points in time, balance sheets are a statement of intent which the business does over a period of time because a lot of times you do tend to capitalize the business ahead of time and thereby the impacts on cash flows are not as significant in the near-term as it ought to be. Hence, the return ratios or return on capital does tend to look significantly lower than adequate or fair return on capital of those businesses. Cash flows are more dependent on the profitability or the underlying business merit as of that moment. The near-term visibility of a business is determined by the cash flow generation capability of a business whereas the longer-term longevity of a business would possibly be driven by how the balance sheet structure is and how capitalization moves. Both of them are not independent factors. It�s interdependent. I would think that cash flows are something which I would be comfortable if I had to look at the next two-three years of business growth and how the underlying businesses are. Balance sheet would be more dependent about the amount of capitalization and the amount of growth needs for a business and thereby the longevity of a business over a period of time. _PAGEBREAK_ Q: The most sticky and tricky analysis regards the debt situation of a company, why is the balance sheet the best indicator of that and how do you go about calculating that? Vora: There are frankly only two ways to raise capital in the country. One is via equity route which fundamentally does tend to be dilutive over a period of time be it for the sponsor or for the shareholders. The second is to grow significantly on the basis of extended capital which could be debt. Obviously, the debt is a function of your own repayment capability over a period of time. It also varies according to a degree of requirement of various businesses. So for instance, a power utility or an infrastructure company might be or even a financial business � will be very comfortable taking a leverage position of over two times the net worth of the business. But, for a lot of other manufacturing businesses that would be significantly overbought. As long as the business has a fair bit of consistent earnings growth, that is maybe backended but the consistency is there �  the leverage is not a big concern in those businesses. But, in certain businesses where there is inherent volatility be it commodity part of the business or certain businesses, which have adequate cashflow generation, they would be wary offtaking too much of debt. So, it is important to look at in what construct one looks at the debt raising and so on. Obviously, it is a function of also your steady state EBITDA generation in the business. Because you also want to ensure that you just borrow as much as is comfortably repayable by the cash flow of the business or the profits of the business that is being generated. So, you have to prepare yourself for a few bad years as you build up your debt profile of the business or you have the risk of going down under in certain cases. Q: Is that also a warning signal while analyzing a company and its balance sheet if the company tends to do recurrent equity dilution in order to raise cash rather than do it through the debt root? Vora: The irony is that recurrent capital raise in any form is dilutive, be it debt or equity. The fact is that every businesses which are growing will also require capital so that is a contra that one is playing with. The only difference to that is, as long as the cash flows of a business starts to rev up and there is adequate return on capital, which is being generated by the existing deployment of capital and thereby fundamentally a higher return on incremental capital that you can generate, I think businesses should look at a fair mix of debt equity. You also don�t want to grow significantly on pure equity because over a period of time, it can create it's own imbalances. You surely don�t want to create a significant leverage in your business. So, I think it is important and pertinent that businesses should stabilize themselves before they keep raising subsequent round of financing. Because the investor also needs to see that there is a value, which has been generated out of the equity that he has invested or the company has the inherent capability to repay debt at a very easy pace over a period of time. Because the cost of debt is over a period of time equivalent to cost of equity. So you don�t want to be lopsided either way. Q: How do you go about calculating where the debt equity ratio is comfortable for a particular business and where it isn�t, just to hug back to our previous example, a debt equity ratio that is very high or out of loop for a construction company or a capital goods company, is a little uncomfortable for someone analyzing it whereas for something that is termed a new business you tend to give it a larger margin? Vora: There is obviously nothing which is sacrosanct in that sense. But, there are certain governance that one needs to adhere to in certain businesses. So for instance if one was looking at aviation for instance maybe a leverage of four-five times would still be plausible. Similarly, in the cases of maybe a power utility that you could go slightly more overleveraged. Because there is maybe visibility of backended returns in certain businesses or in certain businesses equity capital raising itself is extremely challenging or the third part is that if you look at certain asset heavy businesses. Let us assume shipping for instance, you could go slightly higher on debt. But, the same would not work in asset light businesses where ideally the asset light businesses need to throw in a fair bit of cash flows and thereby have a bit of a return on capital. Q: How many examples would you throw up then in terms of analyzing sectors and understanding what a balance sheet ought to or not ought to look like, do you work differently while looking at a commodity balance sheet for instance whereas when you look at something that is a more high growth business, that is a more consumer related business, does the analysis and the parameters of analysis change? Iyer: It does because, the profile and nature of the balance sheet varies from sector to sector. For example, a bank balance sheet would be completely different from what you have for companies in the manufacturing sector. This is because the sheer amount of liabilities and the debt equity ratio would be substantially higher because that is the nature of the business. Again within the manufacturing sector if you were to look at different sectors, different sectors can take different amount of stress as far as the balance sheet is concerned. A commodity company probably has to be more in control of it's gearing given the volatility in the business. Whereas a consumer business has less volatility and in that sense can have a more stable borrowing profile. Likewise again, an infrastructure company, to start with the borrowing number does tend to be on the higher side, they work with gearing ratios in the region of 4:1 whereas, most other manufacturing companies would typically be targeting something like 0.5:1. So, it is very specific to the sector. More importantly, one also has to look at where the company is in its business cycle and in terms of its expansion plan because what you don�t want is to be saddled with a lot of gearing at the top of the business cycle and vise versa. At the top of the cycle, you would want to be a little more careful with your gearing because earnings are going to take a knock down the line. Whereas at the bottom of the business cycle if you see things are improving and you see an uptrend then probably that is the time to take more risk. _PAGEBREAK_ Q: The interesting one is cash reserves, for a lot of people high cash reserves imply that the shareholders have the right to ask the question of what is been done with all this cash but many well performing companies for e.g. even some one like Infosys have extremely high cash reserves on their books? Vora: It�s interesting, as analysts or as investors we tend to penalise both parts of the businesses, businesses which have huge cash reserves but which are not getting deployed and businesses which don�t generate cash and thereby they need to get penalised. The critical part to look at is whether the return on equity of those businesses are adequate enough and they are at a substantially higher level then your ideal cash deployment capability would be at. So, take case of Infosys for example, as long as the overall returns the business generated is higher than your ability to deploy the cash at a suboptimal deployment level. I am perfectly fine as long as cash reserves build up. Obviously, in some sense its not great sign also because over a period if you don�t have adequate deployment capability of your cash it underlies that the business growth is getting limited. Thereby, over a period of time it could get derated also. It�s a function about interpreting the quantitative parts of the balance sheet with the qualitative judgemental part about a business or a sponsor and their capability to run the business over a longer term in time. So, I would think that only part of the exercise is complete by looking at cash reserves and how that�s getting deployed. Whereas the other part is about the consistency of the same and how a managements can deploy that over a period of time. My sense is that in the Indian context, we have historically seen companies and businesses being fairly reluctant to part with their cash reserves. One use of the cash reserves is to pay it out as dividend from the profit that you generate every year that�s one clear deployment capability. Second is to maybe use that cash reserve to maybes shore up your equity holding. Neither of the case in the Indian context has been done to the optimal. Even for businesses which work on negative cash rather on free cash. So, for the investor or the shareholder to look at, ideally if you look at consumer businesses for instance they would work on extremely thin net worth business, they would possibly be paying back close to around 80-90% of profits earned in the business. Because the business doesn�t require too much of capital to run on course. Whereas for lot of other cash rich companies which one is looking at today, be it in the IT or in other domain, there is a potential deployment capability which could be coming through the way of acquisition, and thereby a need to maintain a strong cash reserve. In certain cases it could also be a function about how opportunities can unravel over a period of time and maybe there are new segments that they can address which can be unfolded over next couple of years and they need to maintain cash kitty. As long as they are maintaining a higher return on equity over the cost of deployment of capital of cash, I am pretty okay. Q: Aside from the cash reserve issue there is also one interesting point that has been made by CFOs in the past about off-balance sheet items where you need to analyse not just what you see in two tables on assets and liability side but more importantly the notes to accounts, the kind of references that have been made on spend, the kind of inter-promoter transfers etc, how important are these items for you? Iyer: They are very important both from balance sheet strength and financial strength perspective and also from a governance perspective. This is because it�s very easy for companies to hide a lot of their borrowings and a lot of their problems in off-balance sheet items. It's very important from an analyst perspective to have firm grip on these because typically trouble starts when you transfer the strain from the balance sheet to off the balance sheet items and then eventually comes back and that's when trouble breakouts. Likewise in terms of important issues like promoter disclosures that you mentioned. I guess it's very important to keep an eye on those to have a feel for the kind of stress the company could potentially be exposed to and how the management or the promoter group is going to react to down the line given these business pressures.