Investment research can be quite exciting when you’re watching visionary founders present about their companies or witnessing firsthand the magic of new innovative products. But when it comes to reviewing balance sheets, most investors’ eyes glaze over.
Few would classify the studying of balance sheets as fun, but understanding this financial statement is incredibly important. Even the most disruptive businesses will not last long as public companies if they have weak balance sheets.
Below are three important indicators I look for when determining the strength of a company’s balance sheet.
Note: if you are new to balance sheets, read, “How to Read a Balance Sheet” before proceeding.
1. Healthy current ratio
The first thing I look for on a company’s balance sheet is the ratio of current assets to current liabilities, also called the current ratio.
Current assets are any assets that are either cash or can be converted to cash within a year. On the flip side, current liabilities are obligations the company must pay down within a year.
A current ratio of less than 1 means the company has higher short-term obligations than it has cash on its balance sheet. A current ratio of more than 1 means the company will be able to meet its near-term liabilities.
Here are some examples of current assets:
Cash equivalents — money market funds, short term treasury bills, etc.
Marketable securities — investments such as stocks or bonds.
Accounts receivable — money that is owed to the company by customers within 12 months.
Current liabilities would include categories such as:
Accounts payable (money the company owes to suppliers or vendors within 12 months).
Let’s now review the current ratio of a real company. Below is a snippet of the balance sheet for healthcare technology Doximity (NYSE: DOCS) as of December 2021.
This company has way more current assets than its current liabilities at $858.3 million vs. $91.7 million. This comes out to an impressive current ratio of 9.4. Since this number is much higher than 1, Doximity will have no issues covering its current liabilities in 2022. If you want to be more conservative, you could look only at its truly liquid assets, which would be cash and cash equivalents and marketable securities. Even then, the ratio comes out to 8.3.
Companies with current ratios of less than 1 will need to tap into additional resources (either by taking on long-term debt or issuing more equity) to avoid bankruptcy. A low current ratio does not necessarily mean the business is in trouble, but investors will need to look at the company’s debt structure to understand the finances further.
In Doximity’s case, it has a very high current ratio and zero debt, so it’s safe to say that unless something catastrophic happens, this business will not be going bankrupt anytime soon.
2. Limited “soft” assets
When looking at the total assets on the balance sheet, you might be puzzled by categories like intangible assets or goodwill. These are known as soft assets, and if they represent a significant portion of the company’s total assets, alarm bells should be ringing for investors.
Intangible assets are things like brand value or intellectual property. They need to be accounted for on the balance sheet, but these assets cannot be easily converted into cash, if they can at all. If there is an outsize representation of intangibles in the asset column, you should look for more information to understand why the business believes its intangible assets are worth that much.
Goodwill is a soft asset that’s created when a company makes an acquisition and it pays a higher price than the fair market value (FMV) for the business. The difference in price paid and FMV, in theory, represents the value of all the intangible assets of the acquired business.
Doximity has roughly $18 million in goodwill, which means it paid an $18 million premium for the intangible assets of its recent acquisitions.
It’s normal for a company to pay a premium when making an acquisition, so it’s nothing to be automatically alarmed about. But if the goodwill is a significant portion of the total assets, that could be an indication that the company has grossly overpaid for its recent purchases.
In the example balance sheet above, Doximity’s goodwill and intangibles are very low compared with the overall assets, so nothing too concerning.
The key takeaway is that intangible assets are hard to value. So, if the company is accounting a large portion of its total assets as intangible, that might be a sign of a weak balance sheet.
3. Track record of financial health
A balance sheet is a snapshot of a company’s financial health at a given moment. Thus, it does not tell us how the company’s finances have trended over time. To learn that, investors need to look at past balance sheets and compare.
The table below shows the current assets and liabilities for Doximity from the last four quarters.
With the context of three additional quarters of balance sheet data, you can see Doximity has been steadily improving its finances. It’s even better to have more than three quarters of data to work with, but since Doximity came public in 2021, this is all the reported data investors have access to.
Still, this is a sign of a very financially strong company.
The key to becoming a better investor
This is not an all-encompassing method for analyzing balance sheets by any means, but reviewing these three indicators does provide a quick understanding of a company’s overall financial health.
And while reading balance sheets might not be the most fun aspect of investing, it does make you a better investor with every one you study.
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