Even the best businesses will have unexpected problems and issues. When these occur it is important that the business has sufficient resources to weather the storm and meet its commitments without difficulty.

The Balance Sheet

Even the best businesses will have unexpected problems and issues. When these occur it is important that the business has sufficient resources to weather the storm and meet its commitments without difficulty.

The financial strength of a business is depicted on its Balance Sheet.The balance sheet comes in two parts.

The first part lists the assets of the business: cash, property, goods held in stock, amounts owed by customers, and other items that may be regarded as assets (more on this later).

The second part of the balance sheet lists the liabilities of the business: overdrafts, loans, amounts owed to suppliers and any other liabilities.

The difference between assets and liabilities represents the total profits made by the business from inception to the present. This profit is attributable to the business’ owners so in that respect it is also a liability, and is shown on the balance sheet as shareholders’ equity. It follows that the liabilities section of the balance sheet must always add up to the same total as the assets section – therefore it balances – hence the name ‘balance sheet’.

If the liabilities add up to more than the assets, the business owners’ equity is negative (i.e. the owners ‘owe’ money to the business in order to make it good) and the business is insolvent.

A business with lots of cash and a low figure for liabilities is said to have a strong balance sheet. A business like this is in a strong position to weather short-term problems.

A business with only just enough cash to cover liabilities will have problems making its payments in the event of hard times, and this makes the business a risky investment.

Lack of cash is not always a bad sign – businesses with strong growth prospects and reliable sources of cash flow may need to borrow to maximize their growth potential. But a precarious cash position should be seen at the very least as a major red flag.

Growing Revenues

The balance sheet of a business represents a snapshot in time.

It depicts the assets and liabilities of the business as they were on the date that the balance sheet was produced. Investors are more interested in the future than the present. Or as Markel’s Tom Gayner puts it – he likes to look at a business as if it were a movie not a snapshot.

At the outset of the digital revolution in cameras, a business selling photographic film may have had a strong balance sheet. But what about its prospects?

It is not cash in the bank today that is so important as being able to see a continuous stream of growing future receipts.

The Revenue of a business is the total amount of sales that the business makes. This is sometimes also referred to as Turnover (UK).

If we see a business that has been growing revenue steadily, it gives confidence that the management can execute well and, as long as there are no other factors to the contrary, we can assume that the business has a good chance to grow revenues further in the future.

Growing Profitability

Revenue is important, but revenue that does not lead to profit is worth nothing.

A business may sell a lot of product by pricing it at a low mark-up – showing growing revenues but no corresponding growth in profit.

Good businesses can demand higher prices, and hence enjoy higher mark-ups, which means that growing revenues lead to growing profits. A business that is growing revenues but unable to grow profits may be a sign that the business is struggling to compete on price or is unable to control its costs.

Sometimes there are valid reasons why a business may grow revenues without growing profits. The business may be investing for the future. Amazon has grown revenues fantastically for years, but has rarely shown any profit. Nevertheless, investors in Amazon have been richly rewarded because the market recognizes that it is more important for Amazon to build out a worldwide infrastructure than it is for the company to chase short term profit. The infrastructure will support profits long into the future.

Another reason that a business may grow revenues without profits is to drive out competition. A strong business can sell product below cost, forcing weaker competitors into bankruptcy. When the competitors have disappeared, the business can subsequently raise prices and reap the benefits of an enlarged market share.

This tactic can also be used by small companies as a way to gain a foothold in an established market. The business will attract new customers by setting a competitive price. The hope is that the customers will be so impressed by the quality of the product that they will remain customers even though the company later raises prices.

In summary, growing profits are important, but before ruling out a business on that basis you must decide whether profits have been reduced in the short term for a valid business reason, or whether the lack of profits indicates a genuine weakness in the business.

Strong Cash Flow

‘Turnover is vanity, profit is sanity, but cash is reality’ – Anon.

Cash is the lifeblood of any business. Some businesses devour cash relentlessly. Airlines and public utilities need to spend large amounts of cash before making a single sale. Other businesses seem to generate cash at will. As an example, a web-based retail business, has a low capital requirement, collects cash up-front from its customers, and can sit on that cash for up to sixty days before settling with suppliers.

Insurance is another great example of a cash-rich business. The customer pays a premium immediately, but a claim may not occur for months or years, if at all. The excess cash held by insurance companies is known as Float.

Warren Buffett’s massively successful tenure at Berkshire Hathaway has been a result of the outstanding way in which he has invested the float.

To become a successful investor, it is important to understand the difference between cash flow and profit.

Businesses procuring capital assets must lay out large amounts of cash in the short term. For the purpose of calculating profit, accounting rules dictate that the expense must be spread over many years.

This requirement stems from the Accruals Principle, which states that an income or expense should be charged in the period to which it relates, rather than the period in which payment is made. A firm may spend $10M on a factory, which is expected to generate $2M every year for the next ten years. In this case, the period to which the expense relates, is the expected lifetime of the factory – ten years.

If the accounts were prepared on a cash basis, the expenses in the first year would be $10M set against the income of $2M, resulting in a loss of $8M. For the remaining nine years the accounts would show a profit of $2M – as the cost of the factory had been entirely absorbed in the first year.

Preparing the accounts using the accruals principle, the $10M cost of the factory would be spread evenly over the ten years, resulting in an expense of $1M in each year. This would be offset against the income for each year of $2M, resulting in a profit of $1M for each year.

Most accountants would argue that by eradicating the wild swings in years where there is high capital expenditure, we get a better indication of the underlying performance of the business.

If a business receives cash in advance, the rule applies in reverse. For example, a business may sell a maintenance contract, collecting cash up front. The accruals principle dictates that the income must be broken down into separate amounts spread over the lifetime of the contract.

As a result of the application of the accruals principle, the profit shown on a company’s books can be widely divergent from the flow of cash received or disbursed. Sometimes, it can result in the accounting records presenting a distorted picture of reality. For example a pipeline company may lay a pipe costing $60M that generates income over the next thirty years. A prudent accountant may decide to depreciate the pipeline over ten years – resulting in a charge to the accounts of $6M per year. If the cost of the pipeline had been spread over the full thirty years the charge would have been $2M per year – a $4M difference over the first ten years.

This could result in the pipeline company reporting a $2M loss in its accounts, whereas a more realistic calculation would have shown a $2M profit – potentially creating a huge discrepancy in the share price, and an opportunity for the knowledgeable!

The apparent discrepancy between cash flow and profit has been used to great effect by John Malone. He used the steady, reliable cash flows from the cable TV business to ratchet up debt and make acquisitions. Malone realized that by concentrating on cash flow, he kickstarted a series of virtuous circles.

By depreciating his assets aggressively, he not only wiped out his reported profit, but also his tax liability. This gave him more borrowing power and further scope for acquisitions. By borrowing more he increased his interest expense, which again, he could use to offset more taxes. Because he was expanding rapidly, he had more bargaining power with content providers and was able to buy programmes more cheaply, thus releasing further cash for more acquisitions…

Malone’s relentless focus on cash at the expense of profit was not viewed favourably by Wall Street, where earnings per share was the preferred metric. But early investors in Malone’s business made average annual returns of thirty percent from 1973 until 1998, far outstripping the fourteen percent returned by the S&P 500 over the same period.

Good Return on Capital

Any investment decision must be based on the premise that your funds could not be better used elsewhere.

If you were able to invest cash at zero risk for a return of 2%, why would you make a risky investment in a company that is also likely to return 2%?

Every business has a similar choice. Why would a business make a risky investment in a major factory, if it could make a similar return by depositing the money in a bank? Or for that matter, if a business has nothing better to do with its cash than put it in a bank should it not return that cash as a dividend to its shareholders and let them decide what they want to do with their money?

We give risk capital to businesses in the hope of achieving superior returns. A bank depositor may look for a 2% return. An investor in a corporate bond takes on more risk, but not as much risk as a shareholder. For the bond holder, a return of 6% may be acceptable. A shareholder, taking on the most risk, will be looking for a return of maybe 10%, 12% or more.

The capital of a business comes from the issuance of shares and from taking on debt. Over time the amount of capital available to the business will increase as prior year profits accumulate and become available for investment.

By taking the profit made by a business and dividing by the amount of capital, we can determine the level of return that the business is achieving from that capital. This figure is known as the Return on Capital Employed (ROCE).

The ROCE is the most basic measure of whether the business is using its resources efficiently.

If a business is not able to deliver an acceptable level of return, taking into account the risk inherent in the business, then its capital, and yours, would be better deployed elsewhere.

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