Balance Sheet Analysis Walkthrough

February 3rd, 2009 | Comments (18)

So far, we’ve had a look at the Statement of Cash Flows with AeroGrow with a further discussion on Free Cash Flow, Croc’s Income Statement and now the Balance Sheet for Circuit City.

To help get new investors started, here are some great resources on the Balance Sheet:

  1. Fundamental Analysis: The Balance Sheet
  2. Understanding the Balance Sheet

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So far, we’ve had a look at the Statement of Cash Flows with AeroGrow with a further discussion on Free Cash Flow, Croc’s Income Statement and now the Balance Sheet for Circuit City.

To help get new investors started, here are some great resources on the Balance Sheet:

Circuit City Balance Sheet (click to enlarge)

Balance Sheet Analysis

Balance Sheet Analysis

Cash

Any company with lots of cash is a reassurance to investors that the company should be able to survive during downturns as well as expand during booms.

Divide the cash by the number of shares outstanding to see how much of the stock price is made of cash. On Feb 29, 2008, Circuit City had $1.76 in cash per share but by August 31, 2008, that number dropped to $0.54 and has probably dropped further since then.

If the cash per share is greater than the share price, it could be a potential net net.

Accounts Receivables

As I covered in the Statement of Cash Flows, accounts receivables is an indication of whether the company is able to collect its payments. If accounts receivables decrease from the previous years (you have to compare by going back a few years), the company  has been able to collect its money.

If this is continually increasing, the company is either willing to sell to anyone or the company may have become lenient in its payment policies to customers which could lead to an inflation of earnings causing nasty surprises later on.

Compare the increase in accounts receivable with increase in sales. e.g. If accounts receivables has increased 120% while sales only increased 90%, the company is not collecting bills.

I’ve only displayed a quarterly statement for Circuit City but if we look back at the previous statements, Circuit City has been unsuccessful in reducing this line. Although the sum of $330mil is a good reduction from $447mil in Nov 2007, the overall story shows that Circuit City has an unimpressive payment collection system.

Inventory

One of the most important aspects of the balance sheet. Ben Graham has written that inventory should be marked down to 50% of its valuation when calculating a liquidating value. This is true especially when it comes to electronics. With a product life cycle lasting only a few months, old inventory will continually have to be discounted.

Inventory should also be compared with cost of goods. This inventory indicator is a reliable sign of whether a manufacturer or retail company will stumble if the difference is substantial. In terms of inventory growth, Circuit City hasn’t done too bad of a job but their inventory level is far too high for a business of their size.

It’s also a good idea to compare the inventory turnover with competitors. While Best Buy has been able to turn over its inventory 6.9x times a year for the past 5 years, Circuit City has only managed an average of 5.5x in the past 5 years.

A further discussion of inventory will be required in another post as we look at how companies calculate and state the value of inventory.

One Time Items

Deferred income taxes and income tax receivables should not be considered as part of business assets. They add no value to the operations of the business. Hopefully these numbers are kept low and not included too often. Circuit City needs all the cash it can get. It shouldn’t be overpaying taxes and waiting to receive it without interest from the government.

PP&E and Goodwill

PP&E is an illiquid asset and is mostly taken into consideration when the company is liquidating.

If the company owns land, additional research would be to find today’s market value of the land.

As most readers know, goodwill is best ignored. No tangible value exists and impairment charges usually always appear from a goodwill that is too high.

Although Circuit City “may” have a brand, I believe there is no tangible value because there is nothing stopping a consumer from crossing the road to Best Buy if they have better prices.

Liabilities

Liabilities is much like the assets section. There are payments that have to be made and if this number increases, the company has not been paying their bills.

Circuit City’s problem is that they are overladen with debt and no cash. They need to pay suppliers in excess of $750 mil, expenses in the amount of $270 mil and $343 mil for accrued expenses and other liabilities as well as a short term debt of $215 mil due shortly. With only $91 mil in cash and the rest tied up in inventory, no wonder the suppliers demanded cash up front for delivery of items.

Also, watch out for companies like Circuit City that have accrued so many expenses. These are obligations that must be paid which will hit earnings hard.

Circuit City has also been deferring its rent credits. Companies often abuse deferred charges by pushing expenses into the future so that they can inflate earnings even when things are not going so great.

Circuit City’s “other” liabilities add up to over $150 mil so its always important to check the footnotes as well as the possibility of off balance sheet liabilities.

Quality of assets

Quality of assets is something you should always be asking yourself whenever going through a balance sheet. Circuit City’s assets are made up of mostly inventory, property and equipment. However, we know that electronics cant hold their value for more than a few months and Circuit City does not own their stores (land). So all the stated property and equipment is probably associated to shelves, tables and other shop fitting items. Nothing that can fetch full value.

Quality of assets for Circuit City? BAD

Summing Up

  • Cash helps companies survive and grow.
  • Watch the trend in Accounts Receivables. Be careful of companies unable to collect money.
  • Take the value of inventory stated on the balance sheet with a grain of salt. Different accounting methods (FIFO, LIFO) produce different ending values even though the products are the same.
  • One time items in assets should not appear often such as sale of assets.
  • PP&E is illiquid and should be considered mostly in asset plays or liquidation. Ignore goodwill.
  • All debt isn’t bad. Just when you can’t afford it.
  • Assets should be high quality (cash is best)

This is how you should do proper Balance Sheet Analysis.

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • BP

    You omit probably the biggest reason the company went bankrupt which are the Operating Leases that don’t appear on the balance sheet. This is a huge hidden liability that sinks (and will sink) many retailers.

  • http://www.oldschoolvalue.com Jae Jun

    Hi BP,

    I did mention off balance sheet liabilities. I didn’t go through the entire report but I was pretty sure something like that would be in there.

  • Mark Spiegel

    This company is a pretty poor example to use in regard to “receivables”. If you read the company’s last 10-Q, they only had around 12 days of sales outstanding in A/R, most of which was from the credit card companies. Think about it: who else would really owe them money? A customer would go in there and buy something with either cash or a credit card, and a few days later, Circuit City would get paid by either Visa or Mastercard or Discover or Amex.

  • http://www.oldschoolvalue.com Jae Jun

    True, Circuit City’s receivables isn’t on the bad side but I couldn’t think of a company that had the works. Sorry about that.
    But the point of the post is to watch for the warnings signs. This includes receivables vs sales.

  • Phil B.

    I think in a short amount of space you highlighted key issues affecting CC and what to look for. In my finance class I teach I use Best Buy and Circuit City financials to show good and bad examples when comparing like companies on the income statements, balance sheets and statement of cash flows. CC death warrant starting being written as far back as early 2007 before the crisis even hit and we have been talking about it filing for bankruptcy since the beginning of 2008. It is amazing how often the warning signs creep in well before the company disappears. nice summary analysis here and good example to show students.

  • http://www.oldschoolvalue.com Jae Jun

    Thank you Phil B. There are plenty of other things to look for but hopefully I’ve covered the important aspects to help others in getting started analyzing the financial statements.

  • Ankit Gupta

    I thought I’d make 2 comments here:

    1. Sometimes, analyzing balance sheets and finding bad things is good – you can always short a stock. So if you find a company that makes designer jeans that sell for $300+/pair, and they’re out of fashion, yet their inventory is piled high, there might be a good shorting opportunity if the clothes don’t move at the price they expect them to.

    2. On the topic of debt – maybe I’m just very picky, but when a company has debt and is issuing dividends to stock holders, that’s a situation I don’t like. Opportunity cost says you could have paid down the debt before issuing a dividend, and so you’re essentially taking out debt to issue dividends, which doesn’t make sense. This unfortunately rules out a lot of companies for me, but I just don’t like it.

  • http://www.oldschoolvalue.com Jae Jun

    Hey Ankit,

    I think shorting is for only those that have guts and have the captial. I sure don’t want to be caught in a squeeze. Could end up losing everything even though I may be right.

    I agree with you also on debt and dividends. I don’t like companies that continually distribute or raise dividends just because they have always done it. If they are in a difficult decision, the smart thing would be to pay debt rather than pay shareholders.

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