Balance Sheets Matter Now More Than Ever

"Banks worldwide are hoarding cash in the face of weakening balance sheets, bank failures and an incredible demand from depositors for cash. The result: a complete breakdown in global financial markets," said Paul Kedrosky in Sunday's " Weekend Reading."

You probably already knew (or at least heard) the balance sheet was an important part of any company's health, but did you realize that the numbers on that fundamental financial statement have a direct impact on the credit crunch we're facing?

A Balancing Act

Balance sheets are basically listings of a company's assets (such as cash, receivables from customers and investments), liabilities (debts) and equity (stock owned by investors like you and me).

If you take out a loan to buy a car, your liabilities increase (because of the loan), and your assets increase an equal amount (because you now own a car).

The balance sheet is an important financial statement, because not only does it give you an idea of how much a company owns -- and therefore what it's worth -- it also lets you see what kind of financial trends the company is undergoing, when viewed over time. With the emphasis on liquidity these days (how quickly a company can get cash for its assets), understanding the balance sheet is essential.

You can bet that the balance sheet is one of the very first things analysts look at when they're trying to estimate a stock's value.

When the subprime loan debacle first hit a year ago, financials such as Citigroup ( C) and Merrill Lynch ( MER) wrote down billions of dollars of bad debt that had once been assets on their balance sheets, and their stock prices plummeted as a result.

In 2008, with stock prices fluctuating wildly (check out the CBOE Volatility Index) and "blue chips" looking somewhat less blue, the balance sheet has become more important than ever.

Why?

Simply put, credit is hard to come by.

Scores of companies -- big and small -- use credit to finance their operations from day to day and month to month. With the credit pool drying up, those without the wherewithal on their balance sheets may find themselves in a seriously bad situation.

Even solid borrowers like the State of California are finding themselves in a tough spot. The "Governator," Arnold Schwarzenegger, told the federal government that he may need up to $7 billion to run the state's day-to-day operations.

But all that doesn't mean that there aren't plenty of companies out there with solid balance sheets.

Liquidity Watch

Liquidity is one of the prime concerns in this shaky market. Companies that can pay for their operations with assets such as cash and cash equivalents (including money market holdings and "commercial paper") stand a much better chance of staving off our economy's current problems.

General Motors ( GM) faces a major challenge as it tries to pay its bills with very little cash on its balance sheet. (Right now, only 38% of the company's obligations are covered by its liquid assets.) As a result, the company borrowed the last $3.5 billion available to it this week, and it may resort to mortgaging its headquarters to raise additional cash.

Companies with little or no debt on their balance sheets -- such as Cisco Systems ( CSCO) (no debt until the acquisition of Scientific Atlanta added a modest $6.5 billion to long-term obligations) and Google ( GOOG) (no debt) -- are turning out to be bastions of safety for road-weary investors. Likewise, companies with mainly liquid assets (stocks and cash) or with tangible assets (inventory or land) are looking pretty good too. Simply put, when things turn bad, investors turn to quality.

Betting on Banks

But even though the balance sheet is a little bit of sanity in a crazy market, it's not something you should look at by itself. According to Doug Lamdin, a professor of economics at the University of Maryland, Baltimore County, "A balance sheet, at a point in time, can show important financial circumstances such as the ratio of liquid current assets to current liabilities, or how much debt was used to finance the assets. What a good analysis should include is an examination of how balance sheet items, or ratios, are changing over time, and whether the changes are good or not."

Just look at DuPont ( DD): The chemical giant has seen assets grow 14% in the last five quarters while keeping its debt load essentially flat. That's a good trend.

"Good" is a pretty relative term.

Small regional banks saw triple digit gains in the last month, in part because the rest of the banking industry was in the midst of such catastrophe.

While giants like Washington Mutual (recently bought out by JP Morgan Chase ( JPM)) and Wachovia ( WB) crumbled, BancTrust Financial Group ( BTFG) ( BTFG) saw double-digit returns this quarter, due in no small part to no debt, a growing cash position (up 28% since 2006), and hope for insulation from subprime losses ( research shows that community banks were less likely to dole out subprime loans).

What should you look for when you're trying to pick the next rocket stock?

Well, for starters, don't be fooled into thinking that there are red flags aplenty. According to Lamdin, "If we knew what the red flags were, chances are the stock price would reflect this. There may be smaller less brightly colored ones that one can look for; inventories or accounts payables rising are worth looking into, for example."

If you're looking at a stock with a strong balance sheet, don't forget about just how much valuation plays into the equation. Lamdin says, "A high-quality corporation with an overpriced stock is not a good investment, whereas an average-quality corporation with an underpriced stock is."

Although not all companies with healthy balance sheet numbers are bound for double- or triple-digit glory, those without them are finding themselves in dire straits, as liquidity dries up in the credit market.

Want a chance at making money in 2009? Stick to companies with solid balance sheets.
Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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