Bangkok--21 Oct--Aberdeen
As investors, we tend to obsess over company profits. The size of profits and whether they meet expectations can move share prices and affect how much money, if any, will be paid out in dividends.
During the financial reporting season profits tend to dominate headlines, but seasoned investors are more likely to turn to a company's balance sheet as a better gauge of financial health.
The balance sheet is the part of a firm's financial statement that provides a snapshot of its assets, liabilities and equity.
Used properly, the data can tell investors how much debt a company has, whether there's too much unsold stock, if customers are paying on time, or at the other end of the spectrum, whether a company is investing its surplus cash wisely or perhaps, allowing too much to sit idle.
Hollywood studio Metro-Goldwyn-Mayer filed for Chapter 11 bankruptcy protection in 2010, some five years after a consortium that included Japanese electronics giant Sony took over the company using a form of financial engineering called a leveraged buyout.
That takeover would eventually leave MGM, linked to films such as 'The Wizard of Oz' and 'Gone with the Wind', labouring under an unsustainable debt burden of some US$4 billion.
While the studio is still making films today, having emerged from bankruptcy under the ownership of its former creditors, the sorry affair serves as a cautionary tale highlighting the potential pitfalls associated with excessive debt.
Too much debt scares us. As an investor, we feel much safer when a company offers evidence of a strong balance sheet. Such a robust balance sheet usually means a firm has spare cash to fund corporate expansion or to boost shareholder returns via share buybacks and/or raise dividend pay outs.
How surplus cash is spent can also say a lot about a company.
Alarm bells should start ringing when property developers invest in professional football clubs (as some do in China), or when companies buy exotic financial instruments they barely understand (remember the synthetic collateralised debt obligation?).
Having said all this, management teams have a lot of discretion in the way they present financial numbers because these statements are the sum of many assumptions.
An 'ambitious' treatment of assets can help inflate a balance sheet. Valuing so-called intangible assets – goodwill, intellectual property, brands – can be a subjective exercise, while placing an accurate value on biological assets, such as palm oil and timber, can also be difficult.
Financial officers also have a degree of discretion in the way they treat research and development, either expensing it (incurring a cost) or capitalising it (adding to the balance sheet).
Companies may borrow money by selling so-called hybrid securities that combine attributes of both debt and equity. Instruments such as perpetual bonds allow companies to raise debt and yet, for accounting purposes, they show up as equity on the balance sheet.
Corporate pension obligations can be managed by changing certain assumptions on discount rates, short-term debt can be arranged around key financial dates to dress up a company's debt profile, while analysts often need to be alert for debt incurred that may not be fully reflected on a holding company's balance sheet.
So what's the solution? At Aberdeen, our preference is always for simple businesses because they are easier to understand. If the accounts are too complicated, or the ownership structure unclear, we'd rather not be shareholders.
Hong Kong-listed Cafe de Coral is a great example of a company that we like very much. You can't get much simpler than a profitable chain of fast food restaurants.
It's one of Hong Kong's most recognisable brands for cheap and cheerful Chinese food, and has expanded across the border into other parts of southern China.
But more than that, growth has been financed almost wholly from cash flow and so, Cafe de Coral boasts a healthy balance sheet with minimum debt.
Like a backbone, a balance sheet can tell you a lot about the character of a company.
Find out more at www.aberdeen-asset.co.th/10GoldenRules
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