Tim Bennett Explains: Three Balance Sheet Red Flags

in a previous video I've looked at balance sheet basics what goes into a balance sheet what's the point of it some strengths and weaknesses here I'm going to take most of that knowledge for granted and look at red flags as an investor one of the key questions is when do I know things are going wrong as well as when do i things know when things are going right and a balance sheet can reveal things that could cause you to lose sleep at night someone look at just three of them not the only three but three big ones so with no more ado a quick reminder there's a balance sheet now I'm not gonna go through it line by line but remember the principle is assets at the top what the business is owned okay what the business owns liabilities sort of in the middle that's what we owe short-term and long-term to creditors banks and so on and down the bottom the bit that's described as shareholders funds how it's all been paid for so in other words the contribution from shareholders cumulative that has paid for the net that's assets minus liabilities net assets at the top and being a balance sheet you should all balance so that number should be the same it's that number all right so it's a statement of what the business is worth using accounting rules now how you still is that danger signs I'm gonna look at three areas where you can spot danger in the top half of a balance sheet I'm gonna look at one sort of up here fixed assets now one of those assets is something called goodwill and a goodwill impairment is one of your red flags I'm gonna look in the middle here at the net current assets area otherwise known as working capital a couple of red flags in there I'm not saying these are you must sell your share red flags but certainly pose a few questions you need to know more and the third one is the relationship between sort of longer term liabilities or debt and shareholders funding so I'm gonna look at evidence the management team has got carried away in the past with acquisitions number one number two evidence of liquidity problems and number three evidence of solvency problems and those are quite important questions so here comes the overview and good we'll write offs now first of all what is goodwill goodwill is basically the difference you get when a firm goes out buys another business and pays more than the book value its assets for it so for example if I was to come out and pay very simple numbers 100 million to buy a business and the so called fair value of its assets the things that it owns are only worth 80 million you get 20 million of goodwill all right and is that I'm talking about goodwill why would you overpay to buy a business lots of reasons because when you look through the book alright the assets that attend where you can kick her there but some of them are the reputation the brand the people you pay more for those and as an acquirer of the predator you've got to do something with that 20 million or it creates a kind of accounting headache and me what you do is you stick on the balance sheet and intangible asset you say I paid for the brand the goodwill in this other business it's called goodwill and it sits on the balance sheet as a long-term asset all right now where's he go top of the balance sheet so just to go back it would sit right up here almost right at the top it's one of the first things you see when you look at a balance sheet all right goes right up there at the top why is it written off why would you get management suddenly deciding they've got what's called a goodwill impairment don't worry about the language too much basically the doing is knocking a chunk off goodwill in a banjee writing off against profits or reserves as soon as you see that why would that happen well if you go out and buy a business and you pay 20 billion over the odds for it and you stick that 20 million in your balance sheet so that's fine we'll recover it we'll get it back over time because we've bought the brand the people and so on if at any point in time the management team doesn't think all we overpaid we've got it wrong we pay too much that triggers what's called a good William Hammond hello is this management team saying that 20 million actually we overcooked that we shouldn't have paid as much as we did for that business we better write it off now and the reason it matters is if it happens once it can happen again so in very acquisitive businesses they go out buy lots but the company's the first in the armor the first time things like I'm wrong can be a goodwill impairment and watch out for other ones following down the pipeline it suggests a company that's been busy buying other companies and overpaid in the process so there's number one number two are working capital prices now I'm focusing sort of in the middle of the balance sheet on the so-called current assets and current liabilities otherwise known Countians love jargon as working capital so it's also a kind of working capital crisis going on on this slide now how would I know what am I looking for well working capital is the middle current assets current liabilities are the balance sheet so it's stocks in a sense of inventories Americans call it receivables and cash there's your main short-term assets - short term liabilities creditors payable so interest you text you amounts due to suppliers amounts due to utility companies that kind of thing and the difference the net difference here fifty five million what would i look for first thing I'd look for is is this a business where I expect that to be positive or negative all right most businesses have positive working capital that's because they have money tied up with customers in stock and they have to keep some cash to keep the business running all right so normally their current assets exceed their current liabilities but in some sectors like food retail that numbers negative they should be why because they're in the luxurious position if you're a food retailer like a Tesco for example you've got a lot of money coming through the tills before you ever have to even pay your suppliers all right so you actually run negative working capital so the first thing I ask you sir my expecting it to be positive and network negative that depends on the sector you're looking at so you know industrial manufacturer like a Smiths industries making Boeing aircraft conveyor belts lots of positive working capital food retailer negative there's my first question second question is it changing and why so watch out compared to last year a stocks gone up or down all right if stop shoot up that sales don't warning sign' why maybe the business is over stocking maybe it can't shift the stuff its buying and it's now accumulating in the warehouse and on the balance sheet receivables a sharp increase not selected in sales warning sign okay what's happening is the business losing control over its customers is it extending more and more payment time to its customers maps reflected in a growing receivables balance not reflected in sales I mean yeah the business is growing getting bigger you might expect receivables to increase to because we do give customers some time to pay us but it's the mismatch I'm looking for again on the payable side a sharp increase in payables what's going on there if the business is expanding fine maybe that is justifiable but you don't want to see a mismatch alright is the business relying on taking longer and longer and longer and longer to pay suppliers as a source of finance because that's only a short-term street if you can't keep doing that so basically what I'm looking for is evidence that the management has got this business under control I'm looking for evidence that there is a relationship between what's going on here and what's going on with sales and cost of sales so if the business is growing the balance she's growing with it if it's contracting the value she's contracting with it and I'm also asking myself the question the overall picture positive negative does it stack up with what I know about the sector and some of that requires a little bit of experience to judge number three debt distress now this is looking more at the solvency of the business well I just looked at was the kind of liquidity immediate funding of the business longer term solvency many ways you can calculate gearing how many use just one interest bearing long-term debt the balance sheet long-term loans or interest bearing like a mortgage for you and I as a proportion of equity if you like so if I was to do that if interest bearing long-term debt was let's say 80 million got that in the balance sheet my shareholders funds and equity were let's say 160 million kita numbers really straightforward interest-bearing debt as a percentage of equity would come out and say 50 percent alright 30 percent so what what I'm looking for basically debt distress would be a sudden change in that ratio if gearing's hadn't he left up to 80% or 100% 120% they're asking two questions number one what else is happening in this sector is this just bringing the business I'm looking at in line with other companies or is it suddenly stepped out of line compared to other companies that's quite important and why is this a business that suddenly decide to go on a massive spending expansion spree funded by debt well maybe I can live with that maybe there's a story there but I need to understand what's happening to cause a sharp increase in what's called the gearing ratio and I'd need to check interest cover and that can be done two ways you can look at the profit before interest in profit in lost count as a multiple of the interest charge just like you can do your salary as a multiple of your mortgage interest if you like in terms of can you afford to pay the mortgage can you afford the debt you're carrying or you can do it from a cash flow perspective in future videos I'll look at cash flow statements you can look at the relationship between the operating cash flow generated by the business and the interest cash flowing out for the business alright so there it is quick tour three areas where I'd say you can see balance sheet distress three red flags for investors I'm not saying that you would abandon ship if you see one of these or even all three of these but I am saying you should be asking further questions about the business that was all pretty snappy any questions please contact me at the usual place you

Channel: Killik & Co

Views: 57,600

Rating: 4.9067054 out of 5

Keywords: Red flags, liquidity, solvency, balance sheets, debt distress, leverage, interest cover, impairments, goodwill

Id: EPgqj3V40C8

Length: 10min 48sec (648 seconds)

Published: Wed Jun 18 2014