Issue: 263
Sent: 10-05-2011 10:43:04
In this issue:

Balance Sheets are HistoryA How To Book Of Self Managed Super FundsEmployee Termination Documentation
Return to full article list
HomeFree weekly newsletterSelf Managed Super Fund ArticlesContact usLogin AllThingsConsidered.biz

Balance Sheets are History

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

A strong balance sheet is supposed to be good but it might not say anything about the financial or investment prospects of a company.

Fund managers often talk about using a strong balance sheet as one of the criteria in choosing an investment. A little like motherhood, the importance of balance sheet strength is little questioned.

Balance sheet strength comes principally from some combination of:

Let's say Company A raises $100 million and buys an income producing asset for $80 million that requires $5 million in annual sustaining investment and generates $10 million in EBITDA. Company B borrows $80 million at 6% to buy the same income producing asset for the same profit outcome.

By conventional standards, Company A has the stronger balance sheet. But which company is the better investment?

A good deal of conventional wisdom says the first because it would have a relatively large annual surplus for shareholders. In the second case, the surplus available for shareholders would be one tenth of what it would be for the shareholders of company A.

In this instance, however, shareholders invested in company B are going to get an infinite return on their investments. The shareholders in the Company A, on the other hand, will receive a lower return than the financiers of Company B with considerably more risk.

Yet, if the first investment filter to be applied was "balance sheet strength", company A would come out on top as the investment choice.

The investment attractiveness of a company depends not so much on the size of its balance sheet as on how the balance sheet is used to effect a return for its shareholders.

From a practical standpoint, a strong balance sheet might make it easier to raise capital. BHP Billiton, for example, can command more financial firepower than a company capitalized at, say, $100 million. But if BHP Billiton is simply going to use this financial strength to buy an asset worth $40 billion for $40 billion, as in the failed Potash Corp deal, the benefit of the large balance sheet is unclear.

Large balance sheets imply an historical accumulation of assets and nothing necessarily about future investment returns.

The choice between companies like A and B arises frequently in the context of resource sector investing. Equivalents to Company B are continually raising relatively small amounts of equity capital to push ahead with often disproportionately large projects.

Sundance Resources is probably best known for losing its entire board of directors in a plane crash in 2010. However, it is developing two iron ore mines in west Africa with a likely capital cost around US$4.5 billion, an amount which dwarfs its current balance sheet which, after a $60 million capital raising last month, will have net assets of approximately$ 224 million.

In the resources sector, companies aim to develop mining projects with as much debt as possible so as to maximize the return to equity holders. Companies manage to do this to varying degrees. Some, admittedly, are entirely unsuccessful. However, the attractiveness of the investments bears little relationship to the strength of the company's balance sheet.

These points are not confined to resources companies. Microsoft has a very strong balance sheet. At the end of March, it had net cash reserves of US$50.2 billion and net equity of US$99.7 billion. Its balance sheet is very much a product of a history of groundbreaking innovation. Any investor would have loved the 19% per annum appreciation in its share price since 1990. But the share price since 2001 has returned zero while Apple Inc, for example, has delivered a 3,700% rise.

The challenge for Microsoft, notwithstanding its history, is to come up with enough new ideas on a sufficiently large scale to provide an adequate return on the funds it is holding.

Similar examples can be found in the pharmaceutical industry. Merck, for example, has a strong balance sheet - $12.2 billion in cash, $17.8 billion in debt and $54 billion in shareholder equity - but its fortunes depend increasingly on four influences:

The Merck balance sheet is good to have but is reflective of a history which is the mirror image of the era it is entering. Not surprisingly, its share price has been declining at an average annual rate of 5.5% for the last ten years.

This is not to say that the size of a balance sheet is entirely irrelevant. However, equity investment products that start with the balance sheet are saying "buy history".

An investment product that lines up everything else and then uses balance sheet strength as a final differentiating feature is more likely to get the choice right because it recognizes that future cash flows (and capital minimization) generate value and that balance sheets are largely about historical outcomes.


Share this article
Click to share this article on Facebook Click to share this article on Twitter

Previous article         Next article

 
If you liked this article and would like more by email, subscribe! It's free.

[Bold fields are required]

Your details

Your alternate email address is used only if messages to your primary email address are returned to us.

Industry

Do you work in the financial services industry?

This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.

 
 
Site design by Raycon