Balance sheet, debt leverage and risks

The balance sheet forms the third pillar for figure-based assessment of the company, with the other two being the income statement and the cash flow statement. The balance sheet indicates where the company's money has come from and where it has gone. The balance sheet is a static snapshot at a given time, while the income statement and cash flow statement are dynamic and describe events over a given time period.

 

The importance and premise of examining the balance sheet

The balance sheet consists of two sides, where equity and liabilities represent the amount of capital invested in the company by the owners and the amount of retained (not yet distributed) earnings, as well as the amount of interest-bearing and non-interest-bearing liabilities. The asset side of the balance sheet describes the company’s amount of tangible and intangible assets and receivables. The equity and liabilities side of the balance sheet can be considered from the bottom up as the repayment order of liabilities and the assets side as the liquidation order of assets. This order is descriptive and not absolutely strict.    

Although companies and their shares are usually valued based on the company's growth and profitability, i.e. factors shown in the income statement, the balance sheet should never be ignored in the examination. The link between the income statement and the balance sheet is clear and unbroken through the cash flow statement. Cash flow usually correlated well with earnings and ends up in the balance sheet and eventually to investors. Ultimately, the balance sheet either creates conditions for a growing and profitable business, i.e. good development evident in the profit and loss account, or destroys them.

Traditionally, debt investors have paid far more attention to the balance sheet than equity investors, as their primary interest even above returns is to avoid credit losses. A strong balance sheet has a large number of asset items that can be sold if necessary and thus at least creditors will get their own. For equity investors, it is more important that the business generates shareholder value. However, in a more uncertain market, equity investors also need to pay attention to how the company will survive a crisis without permanent damage. The risk of bankruptcy is obviously elevated in crises, but shareholders’ returns can also be affected by expensive financing solutions (highly diluting share issues or expensive hybrid loans) or heavy indebtedness as such. In addition, the last point may prevent getting new debt capital and also refinancing of existing loans when they mature.

The key issue for the investor is that the company's balance sheet is appropriate and risk resistant. Appropriateness requires that all balance sheet items must serve the implementation of the company's business idea and strategy, i.e. there are no unnecessary or particularly risky items in the balance sheet, and on the other hand no essentials are missing. Risk resistance means that the balance sheet contains sufficient buffer to withstand negative business cycles, failures and write-downs without the company having to immediately turn to either external financiers or owners to obtain additional funding.

Items requiring particular attention in the balance sheet

When examining the asset side of the balance sheet, special attention should be paid to intangible assets such as: 

- Capitalized product development costs

- Asset items created by acquisitions to be depreciated (deal price allocation, or so-called PPA depreciation)

- Goodwill that is not amortized in principle

All of these may also have a material impact on the reported result. In addition, interesting questions concerning the company's solvency include whether the company owns its own headquarter (can be sold and start renting in case of problems) and how much the balance sheet and debt are inflated by partly artificial IFRS 16 lease liability recognition. 

The introduction of the IFRS16 standard moved companies’ leases of over 12 months into the balance sheet, where they are depreciated and “invested” when contracts are concluded. Although there are risks associated with long lease contracts, their introduction into the balance sheet did not really clarify the situation. The balance sheets of some companies can appear massive, although in reality the IFRS16 recognition does not tie up capital unless usually moderate rent deposits are included. A long-term lease can sometimes also be a strength and reduces risk, but now from the balance sheet viewpoint keeping leases under 12 months is sensible.

The following figure shows the most interesting items in the balance sheet and brief comments on them. However, the high importance of differences between companies must be considered at all times. Glaston has been used as an example and certain observations can be made on its balance sheet structure. However, the comments below are mostly general in nature.

Glaston’s balance sheet 12/31/2021, EUR 1,000

 

In Glaston's balance sheet, focus turns to the large goodwill (30% of the balance sheet). However, after big M&A transactions over the past decade, many other industrial companies have about 20% goodwill in the balance sheet. Companies with significant goodwill should have strong equity, because even if the potential goodwill impairment write-down would not affect cash flow, it would eat away on the company's equity. 

In working capital financing Glaston’s situation is favorable as, especially thanks to high advances received the net working capital is EUR 12,609 negative (27,277 + 17,115 + 14,322) - (15,853 + 36,334 + 17,073 + 2,063). Thus, the company can finance its other activities with non-interest-bearing current debt. However, the situation is unusual. In their balance sheet analysis, the investor should pay attention to the turnover times of inventories, trade receivable and accounts payable and deviations relative to peer companies and the company's own history. Longer turnover times indicate increased obsolescence risk (inventory) and credit loss risk (trade receivables).

Traditional balance sheet indicators and their interpretation

Often the balance sheet is only examined superficially with indicators, the most common of which are gearing and equity ratio. If these levels are excellent and the company, for example, has no net debt, the balance sheet analysis can generally be kept to a minimum. However, it is more common that the company has interest-bearing net debt and then a more in-depth examination may be required, depending on the situation. Prolongation of the above-mentioned turnover times is also a sign of danger.

The table below shows the three most used balance sheet ratios calculated based on Glaston’s 2021 figures presented above. The table also includes “reference values” and balance sheet ratios below these indicate a burdened balance sheet and limited risk tolerance. These figures are not universal either, but, for example, real estate investment companies normally tolerate a much higher level of gearing than manufacturing companies or service companies. This is due to the traditionally low operational risk in the real estate investment sector. Glaston's balance sheet at the end of 2021 is strong, at least with traditional indicators, and its risk tolerance is good.

With the indicators used in the table Glaston's consolidated balance sheet is strong. The “alarm limits” of the various indicators are indicative values. If one or several of the indicators of the investment target are below the limit the investor should look more closely at:

- The background of the weak indicators (non-recurring or recurring reasons)

- Expected development of the figures

- Business continuity

- Predictability and volatility of the result

- The balance sheet relative to peer companies

- Consider their own risk tolerance

The “alarm limits” for the equity ratio and gearing are set by us and the net debt/EBITDA alarm limit is the limit set by Standard & Poor’s for the “aggressive” financing risk profile in a company with average cyclicality. 

The above indicators are balance sheet-based risk indicators and ultimately reflect the company's ability to meet its obligations. Equally interesting balance sheet related figures for the investor are the return on investment and return on equity which reflect the efficiency of the use of capital made available to the company. 

Credit rating and its meaning

An examination limited to one or a couple indicators is often too limited. Credit rating agencies (e.g. Standard & Poor’s) base their credit ratings on three elements: 

An official credit rating is practically required for international bond issues. Standard & Poor’s credit ratings and credit ratings in general have two levels: 

At the investment grade level, access to finance is generally good and the return required by investors is reasonable, while at the speculative grade level the cost of financing increases sharply and when moving toward the weakest ratings in the level, access to finance virtually stops. Although shareholders always come last relative to other creditors in a potential company liquidation, published credit ratings are important in assessing the company's financing possibilities and the price of financing, as well as the risk profile as a whole. Therefore, credit ratings are also interesting to equity investors 

Optimal capital structure

The optimal capital structure of the company optimizes the equity/debt ratio, i.e. minimizes the weighted average cost of capital (WACC) while maximizing the value of the company's equity. In principle, the cost of debt is always lower than the cost of equity, since interest payments have priority over dividends, in company liquidation debts have priority over shares and interests are tax-deductible. From this viewpoint, strong indebtedness would be positive for the company itself. However, excessive debt increases the company's interest expenses, increases the volatility of earnings, and elevates the risk of bankruptcy as equity buffers are low. Due to the rising risk, shareholders’ required return also increases and this increases the WACC.

Since the optimal equity/debt ratio can only be determined with full information, the management of the company optimizes the capital structure within a certain framework. The issues to be solved include:

Cyclicality of the business

- Companies in cyclical sectors need more equity to ensure their ability to settle debts at all stages of the economic cycle.

- On the other hand, companies generating stable cash flow (e.g. operators) can be clearly indebted while minimizing the cost of capital.

Capital structure compared to other companies in the same sector

- Significant deviations to comparable companies and the reasons for such deviations should be examined and any corrective measures taken.   

Access to debt financing and the price of financing

- If the company's assets consist mainly of intangible assets, it is difficult to acquire traditional debt financing based on real collateral.

- Real collateral can be fully or partially replaced by covenants (financial and other covenants), but their terms and conditions may be difficult to accept for the company's management and owners.

The message sent to the market by increasing equity (share issue) or debt (lending) financing

- As debt is a cheaper source of finance than equity, further indebtedness, e.g., for investment, can be interpreted as positive on the market, while a share issue for the same purpose raises suspicion.

The following is an illustrative example of a fictitious company and its cost of capital with different financing structures A-G. In a company with a strong balance sheet and that is in good condition, the return requirement for both equity and debt is relatively low (structure G), but as gearing increases and after a certain tolerance level (structures C and D), the return requirement for both equity and debt start to rise rapidly (structures A and B). The optimal capital structure of the example company is D, where WACC is the lowest.

An illustrative example of the cost of capital for company X under different financing structures

In the example below, financial structures F and G already begin to indicate that the balance sheet is overcapitalized, i.e. too low use of leverage. Well-founded reasons for funding structures such as F and G may include the company's strong cyclicality/seasonal variation or preparing for major investments ahead. An example of overcapitalization among Finnish industrial companies is the elevator and escalator manufacturer KONE whose net gearing was -68% and net assets EUR 2,164 million at the end of 2021. Due to a strong and consistent maintenance business KONE’s overcapitalized balance sheet cannot be justified, at least with business cyclicality.

Investor checklist and summary

The importance of the balance sheet to investors is again clearly growing as the global economic outlook is uncertain at best and interest levels are rising. When assessing investment targets, an investor should have an understanding of at least the following:

1. Risk tolerance of the balance sheet (equity, net gearing and net debt/EBITDA ratio) relative to the business outlook, rising interest rate level, business cyclicality and peer companies.

2. Balance-sheet position relative to the set targets. Can the company pay dividends in line with its dividend policy without jeopardizing its balance sheet position?

3. Balance sheet items included in equity but that have priority over share capital such as capital loans and their interest rate level.

4. Other expensive debt instruments that may have arisen during, e.g., a previous profitability crisis. What is their interest rate, repayment program and possible financial covenants?

5. Currency structure, interest rate and refinancing risk of ordinary debt financing (bank loans, bonds).

6. Historical investments relative to depreciation. Has the company accumulated investment debt, the financing of which is uncertain in terms of the balance sheet position?

7. The amount of intangible assets (goodwill, capitalized product development costs) on the asset side of the balance sheet and the adequacy of equity to cover possible write-downs.

8. The financing needs and development of net working capital (inventories + non-interest-bearing assets/non-interest-bearing liabilities).

If the key balance sheet indicators are good, the investor's interest depends on the company’s business model and capital intensity, i.e. the role of the balance sheet in the business. For example, for manufacturing companies key is the company's factories competitiveness and the need to maintain it, and for software companies the importance of capitalized development costs. On the other hand, in the case of a profitable service company with very little debt, the importance of the balance sheet is very limited to the investor.

Read next

Equity Research Insights: Strategy

Equity Research Insights: Data sources and background work

Equity Research Insights: Forecasting

Equity Research Insights: Research process