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Corporate Balance Sheets Look Grim

Balance sheets for most S&P 500 firms aren't nearly as healthy as they are perceived to be, some say.

If you think corporate balance sheets are generally better today after the financial scandals of the last three years, then you might want to think again.

Balance sheets for most firms in the

S&P 500

are nowhere near as healthy as they are perceived to be, at least according to some analysts.

Although cash levels have grown recently, Merrill Lynch analyst Richard Bernstein said they have been building "at a very anemic pace" compared to liabilities. In addition, he said debt-to-equity ratios haven't improved in the last few years, and companies are finding it as hard as ever to meet interest payments on outstanding debt.

Bernstein examined data for only the S&P industrials, which amount to 373 companies in the S&P 500. Financials, utilities and transportation stocks were excluded from the analysis because those sectors could distort the results, Bernstein reasoned.

The findings are significant, not only because they potentially dispel one of the notions that has been driving asset prices in recent months, but also because they suggest that capital spending is likely to remain weak.

Since last October, corporate bonds have soared because investors have felt that companies were finally shoring up their balance sheets after years of excess. Meanwhile, the


has jumped more than 30%, while the


and S&P 500 have climbed about 18%, partly on a perception that firms have been accumulating cash, paying down debt and generally improving their financial metrics.

To be sure, some things changed for the better last year, as firms slashed capital expenditures and acquisitions. Commerzbank high-yield strategist Gretchen Rodkey-Clark noted that free cash flow rose to $124 billion in 2002 from a negative $20 billion in the prior year. Still, she said, only the telecom sector actually made any significant progress in reducing debt last year, and that was because the group was under "considerable rating agency and investor pressure to do so."

"Balance sheet repair is a slow, slow process," she said. "I suspect we'll find that net debt levels didn't fall in the first quarter."

While cash has been building, she said the increase hasn't been dramatic compared to the $1.8 trillion of liabilities held by the nonfinancial companies in the S&P 500. Rodkey-Clarke said she excludes financials from her analysis because they have so much debt that it dwarfs that of other firms, and that can distort results.

With writedowns and write-offs outpacing debt reduction, some analysts say the trend toward greater leverage is still very much in place. A writedown is when a firm reduces the book value of an asset because it is overvalued.

In addition, some analysts suggest that pretax interest coverage ratios haven't improved over the past six or seven years, with Bernstein suggesting that things have "marginally deteriorated more recently." That suggests companies have been unsuccessful in swapping high-interest debt for low-interest debt.

"These data do not argue positively for a cheaper cost of capital used to externally fund capital spending," Bernstein said.

Rodkey-Clark agrees that spending will probably be "muted" this year, especially because she expects corporate profits to be weak. But she feels corporate balance sheets will gradually improve over the course of the year and that the financial markets have been pricing that in.

Bernstein did point to a couple of positive developments: Current assets have been growing relative to current liabilities, and current liquid assets (for example, cash and marketable securities) have improved compared to current liabilities. Still, he said most of the improvement can be put down to a cash buildup in the technology sector. Cash represented more than 30% of total assets for the typical tech firm, he said, more than twice that of companies in other sectors. Excluding technology, however, the short-term portion of the balance sheet is still "rather strained compared to history," he said.

"It seems as though investors' focus on free cash flow has potentially led to misleading conclusions regarding the extent of balance sheet repair," Bernstein said.

Nevertheless, the analyst did note that some firms have done a good job of reducing their debt load recently. Specifically, he likes the balance sheets of

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Bernstein also likes the balance sheets of

Federated Dept. Stores





Jones Apparel


, among others.