Tim Bennett Explains: Three Balance Sheet Red Flags

In a previous video, I discussed the basics of the

balance

sheet

. What does a

balance

sheet

include? What is the point? Some strengths and weaknesses. Here I'll take most of that knowledge for granted and discuss the red

flags

as an investor. The key question is when do I know things are going wrong? And when do I know when things are going well? A balance sheet can reveal things that could cause you to lose sleep at night. just

three

, but

three

big ones, so without further ado, a quick reminder that there is a balance sheet. Now I'm not going to go through it line by line, but remember the beginning is the assets at the top, what the company owns, okay, what the liabilities of the company are. more or less in the middle, that is what we owe in the short and long term to creditors, banks, etc., and towards the bottom, the part that is described as shareholders' funds, how everything has been paid, in others In words, the cumulative contribution of the shareholders who have paid for the net, that is, assets minus liabilities, net assets on top and being a balance sheet, they all have to balance so that that number is the same, it is that number, okay, so it's a statement of what the business is worth using accounting rules, now how Still are the danger signs.

I'm going to look at three areas where danger can be detected in the top half of a balance sheet. I'm going to look at a type of fixed assets up here. One of those assets is something called goodwill and a deterioration of goodwill is one of its warning signs. I'm going to look in the middle here, in the area of ​​net current assets, also known as working capital, a couple of red

flags

there. I'm not saying these are red flags that you should sell your shares, but it certainly raises some questions that you need to know more about and the third is the relationship between the type of liabilities or long-term debt and shareholder financing, So I'm going to look at the evidence that the management team has gotten carried away in the past with acquisitions number one.

Evidence number two of liquidity problems and evidence number three of solvency problems and those are pretty important questions, so here comes the overview and well, now we'll cancel out, first of all, what goodwill is. Goodwill is basically the difference you get when a company exits. You buy another company and you pay more than the book value of its assets, so, for example, if you went out and paid very simple figures, 100 million to buy a company and the so-called fair value of its assets, the things you own are only With a value of 80 million, you get 20 million of goodwill, and I'm talking about goodwill, why would you pay more to buy a business?

There are many reasons because when you look at the book, the assets that are where you can kick it there, but some of them are the reputation, the brand, the people, you pay more for them and as the predator acquirer, you have to do something with those 20 million or it will create some kind of accounting headache and I, what you do is you move on. the balance sheet and the intangible asset you say I paid for the brand the goodwill in this other business is called goodwill and it's on the balance sheet as a long-term asset right now where is he at the top of the balance sheet?

Again, it would be up here, almost at the top, it's one of the first things you see when you look at a balance sheet. Okay, it goes up there, at the top, why is it canceled? Why does management suddenly decide that they? I have what is called a deterioration of goodwill, don't worry too much about the language, basically what you do is take a part of the goodwill in a banjee, writing it off against profits or reserves as soon as you see that why would it happen That's fine if you go out and buy a business and pay 20 billion over the odds and keep that 20 million on your balance sheet, so that's fine, we'll get it back, we'll get it back over time because we've bought the brand, the people, etc. .

If at some point the management team does not believe that all we overpay is that we are wrong, we pay too much, which triggers what is called a good William Hammond. Hi, is this management team saying that 20 million is actually overcooked and that we shouldn't? We haven't paid as much as we did for that business, we better cancel it now and the reason it matters is that if it happens once it can happen again, so in very acquisitive businesses they go out and buy lots, but the company It is the first in armor. The first time things like I'm wrong can be a deterioration of goodwill and be wary of others following the process, it suggests a company that has been busy buying other companies and overpaying in the process, so the number one, number two, is working capital prices now.

I am focusing in the middle of the balance sheet on the so-called current assets and current liabilities, also known as. Counties love lingo like working capital, so it's also kind of a working capital crisis on this slide. How could I know? That I am looking for? Well, working capital is the average current asset. Current liabilities are the balance sheet, so they are stocks in the sense of inventories. Americans call it accounts receivable and cash. There are your main short-term assets: short-term liabilities. Creditors to pay, so you are interested. you, the amounts owed to the suppliers, the amounts owed to the utility companies, that type of thing and the difference, the net difference here, fifty-five million.

The first thing I would look for is whether this is a business that I expect to be positive or negative. Granted, most companies have positive working capital because they have money tied up with customers in stock and they have to hold some cash to keep the business running well, so typically their current assets exceed their current liabilities, but in some sectors, such as food retail, that The numbers are negative, should be the reason because they are in a luxurious position. If you are a food retailer like Tesco, for example, you have a lot of money in the tills before you have to pay your suppliers. actually you have negative working capital so the first thing I ask you sir is I hope it is positive and net is negative that depends on the sector you are looking at so you know an industrial manufacturer like Smiths Industries which manufactures conveyor belts for Boeing airplanes. negative food retail working capital that's my first question, second question is it changing and why so be careful compared to last year? maybe you can't transfer the things you're buying and now it's piling up in the warehouse and on the balance sheet accounts receivable a sharp unselected increase in sales warning sign okay, what's happening is the company is losing control on its customers, it is extending more and more payments time to its customers is reflected in a growing accounts receivable balance, it is not reflected in sales.

I mean, yes, the business is growing, accounts receivable can be expected to increase because we give customers some time to pay us, but what I'm looking for is the mismatch. again on the accounts payable side, a sharp increase in accounts payable, what's happening there if the business is expanding well, maybe that's justifiable, but you don't want to see a mismatch, okay? Does the business depend on taking longer and longer and longer and longer to pay? suppliers as a source of funding because that's only a short term path if you can't keep doing it so basically what I'm looking for is evidence that management has this business under control.

I'm looking for evidence that there is a relationship between what is happening here and what is happening with sales and cost of sales, so that if the business is growing, the balance is growing with it, if it is contracting, the value that is contracting, and I also ask myself the question about the bigger picture. Positive Negative Does it compare to what I know about the sector? Some of that requires a little experience to judge debt problem number three. Now this focuses more on the solvency of the business. Well, what I just analyzed was the type of liquidity. immediate financing of the company long-term solvency many ways to calculate leverage how many use only long-term interest-bearing debt the balance sheet long-term or interest-bearing loans such as a mortgage for you and me as a proportion of equity , if you want then, if I were to do that, if the long-term interest-bearing debt was, let's say, 80 million, that on the balance sheet my shareholders' funds and capital were, let's say, 160 million kita, really simple figures, would come the debt that accrues interest as a percentage of the capital.

I come out and say 50 percent, okay, 30 percent, so basically what I'm looking for is debt overhang, it would be a sudden change in that ratio if the leverage hadn't left it up to 80% or 100% 120%, they're asking two questions number. One of the things that is happening the most in this sector is simply aligning the business that I am looking at with other companies or does it suddenly go out of line compared to other companies, that is quite important and why is it a business that suddenly decides to go away . in a wave of massive debt-financed spending expansion, well maybe I can live with that, maybe there is a story there, but I need to understand what is happening to cause a sharp increase in what is called the leverage ratio and I would need check interest coverage and that.

It can be done in two ways: you can look at earnings before interest, gains on losses, count as a multiple of the interest charge, just as you can make your salary as a multiple of your mortgage interest, if you wish. , in terms of whether you can afford to pay. the mortgage, can you pay off the debt that you have or can you do it from a cash flow perspective? In future videos I will look at the cash flow statements. You can look at the relationship between the operating cash flow generated by the business and interest. cash flow for the business, okay, so here's a quick tour of three areas where I would say you can see problems on the balance sheet.

Three warning signs for investors. I'm not saying you would abandon ship if you see one or even all of these. three of these, but I say you should ask more questions about the business, everything went pretty quickly. If you have any questions, please contact me in the usual place.