Security Analysis Series: Chapter 45 Summary

“Balance-Sheet Analysis (Concluded)”

Chapter Summary

  • The primary role of balance sheet analysis in valuations is typically to detect weakness in the financial position of the company, rather than confirming strength. What threats might come to fruition as a result of future developments or events? (pg 591).
  • The appropriate amount of working capital must be determined by the investor rather than a strict, inflexible generalized ratio. It varies from industry to industry and company to company. Graham generally recommends at least a 2:1 WC ratio, but encourages the investor to develop his own number for an appropriate margin of safety. (pg 592).
  • Significant amounts of short term bank loans or debt is frequently a signal of a company under pressure. Placing bets on companies that are heavily indebted yet offer attractive upside in the case of growth is unwise. This is because the debt is “very real and very menacing”, while growth is only prospective. (pg 595).
    • If earnings are substantial, a company will rarely become insolvent from bank loans, but rather suspend the dividend instead. (pg 595).
    • Indebtedness to parent or affiliate companies are “theoretically as serious” as other short term liabilities, but it is rare to see payments actually claimed. It is less problematic than bank loans. (pg 596).
  • “Maturing funded debt is a frequent cause of insolvency.” Beware the company’s bonds hold a very high yield, as this is a sure sign of trouble ahead if the price is exceptionally low. (pg 597).
  • Balance sheet comparison of the same company over time is key to determine the effect of profit and loss, and the relationship between earning power and the balance sheet. Appropriate restatements and adjustments of certain accounts are required to make this comparison relevant. For example, frequent charges to surplus across a number of years can be a significant detriment to earning power in future years. The analyst must determine if those charges will have that effect. (pg 598).
    • Years of loss instead of profit can represent a good buying opportunity if the financial position of the company has improved so dramatically over the years as to offer a greater margin of safety. (pg 600).
    • Taking losses on inventories might actaully serve to strengthen financial position. This is because liquidating value of inventory is calculated at something close to 50-75%, while the cash earned from the losses on inventory will be 100% represented in liquidation calculations. In other words, an operating loss to the company might represent a gain in liquidating valuation for the investor. (pg 602).
  • Graham presents an interesting conundrum, in that if the market price of an inventory good has gone down by 50%, and writedowns are necessary, shouldn’t the fixed assets that generated that inventory also be marked down? He doesn’t provide an answer to this, but rather presents it as a question for the reader. (pg 604).
    • Conversely, inventory inflation profits should be viewed with care. Significant advancements in the price of inventory will lead to more and easier credit based on the overvalued inventories, which may bring about trouble if the price returns to normal. (pg 605).

Chapter Thoughts and Analysis

  • The summation of Graham’s section on the balance sheet essentially repeats the mantras that have filled the entire book. And primarily that is the principles of conservatism and logic. Are the current assets fit enough to cover future threats? What are those future threats, and the signs of them? What could this stock be liquidated for today, and are the percentages we have applied to the asset values appropriate in the context of the company? I think the answers to many of these questions are easily answered by simply knowing the company and the industry. Perhaps this is why Buffett always stresses this idea in interviews: it seems to be one of the main underrated lessons of Security Analysis.
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