Investors need to use both sides of their brains.
Yes, there’s the analytic side and the intuitive side. There’s numerical number-crunching and there’s aha-moment insight, the kind that gets into Apple at 30 and out of Amazon at 650. But that’s not the two-sidedness that I’m talking about.
I mean the balance sheet. Yes, that boring, accounting-level statement of what a business owns and owes. The statement of cash, receivables, inventory, property and equipment on one side, and payables, short-term loans, long-term loans, and equity on the other side: assets and liabilities—both sides.
For a long time the balance sheet was the Rodney Dangerfield of accounting: it didn’t get no respect. After the dot-com bust and Enron scandals analysts focused on earnings and cash-flow, respectively. But it took the financial crisis to raise the prospects of the balance sheet.
The balance sheet gives you an inside picture of a company’s financial health. Assets—and especially liquid assets—indicate how well they can deal with stress. And liabilities, particularly short-term borrowings, show where that stress might come from. When short-term loans are too high relative to cash and other liquid assets, creditors can shut down a company by just walking away. During the Depression some banks had three-quarters of their assets in cash, not because they were sick, but because they were healthy, and wanted to stay that way.
The truth is, all three accounting statements are important: earnings, cash-flow, and the balance sheet. In combination, and over time, they show what’s going on inside. But it’s the balance sheet that shows when things are out of balance.
Douglas R. Tengdin, CFA
Chief Investment Officer