Balance Sheet Analysis

I believe that the balance sheet is by far the most important financial statement that needs to be analyzed before buying a stock.

Many investors will spend time trying to divine future cash-flows, revenues etc. But a simple balance sheet analysis is usually sufficient to make a yes or no investment decision, or at least screen out 90% of bad investment candidates.

Without getting too deep into financial statement analysis, the first thing I look for is a large cash position that more than covers any conceivable type of debt. The reason for a large cash balance is simple: It reduces downside risk in a stock and provides ample capital for a company to pursue growth in a manner favorable to existing shareholders.

I tend to try to buy stocks that have at least 20% of their market cap in net cash (cash minus all debt instruments). That number is a bit arbitrary, but my thinking is that most companies have no need for all the cash they pile up and with a bit of activism it is conceivable to get management to use a bulk of their cash for a dividend or stock buyback. With 20% of the market cap in cash, I estimate that a company can return about 15% to shareholders via stock buybacks and dividends. I do make exceptions to the rule above, once in a while, but this is primarily either because I missed something in my analysis or I´ve become too speculative (I´m really gambling). Sticking to the 20% rule is probably the best way to screen out bad investments.

A couple of caveats for balance sheet analysis:

• You need to compare the balance sheet quarter to quarter, to make sure the company´s cash balance is increasing due to sound ongoing operational events, rather than "unsustainable" business practices (i.e. not paying bills, off balance arrangements, sales of worthless equity, option excercises etc .). In fact, you don´t even really need to look at any other financial statement if you can compare balance sheets well. Almost, everything shows up on the balance sheet or in footnotes to the balance sheet.

• Try to stay away from companies with preferred or convertible debt instruments.  These are not always toxic, but in general you need to be extra careful in your analysis of these situations and be sure the overall cash balance far exceeds the value of these financing instruments.

• Stay away from companies with a high cash balance, but no real ongoing business. I´ve gotten suckered into cash plays in the past (i.e. where the share price is beneath the total cash on the books), but, my experience has been that the return from these stocks is terrible relative to what you could have gotten in a stock with a good cash balance and a solid ongoing business. Yes, the risk is low in these cases, but the return is also low. In general, management will suck away cash from these companies at an alarming rate. So before you know it, the cash rich balance sheet is cash poor.