The first is excessive debt. Ignoring risk in the balance sheet risk can lead to some bad investments. The companies within your portfolio with weak balance sheets - high borrowings - are the ones that will depress portfolio returns when the economy or an industry goes through a rough patch.
Even if they do not go bust, they may find that their bankers force them to make disposals of divisions to bring down their debt levels. Unfortunately, prospective buyers will often spot they are a forced seller and the price received is reduced to levels below what the company and investor thought they were worth.
Given that an investor has to pay as much attention to avoiding disasters as to picking winners then sidestepping highly geared firms is one way to hold fewer losers.
As well as straight-forward debt you should take into account pension fund deficits and the value of redeemable convertible preference shares where the likelihood of conversion is slim.
Also consider the debt maturity profile: what has to be repaid this year, next year, and so on.
Debt covenants may be onerous for shareholders so check them out.
Some companies select year-end dates when their seasonal cash flows are at a high point. In these cases, the analyst should look beyond the absolute debt levels at the year-end and consider the debt through the year.
The amount paid in interest for the year may be of some help here – if it seems high relative to the year-end debt and prevailing interest rates then, perhaps the debt levels for much of the year were much higher than those reported at the year-end.
Half-year balance sheets often have raised debt levels so it is worth looking at a few years-worth of those.
As regular readers know I regard Piotroski type analysis of financial distress risk, which focuses particularly on the trend in key accounting variables, as useful for getting a handle on the likelihood of the company struggling.
I’m not saying that I will never own a company with a weakened balance sheet – look at Smiths News - but that I will do so with his eyes open and then pay special attention to its progress (I’m expecting Smiths News to reduce its debt dramatically over the next 12 months given its great cash flow).
Will the business genera
Prof. Glen Arnold
I'm a full-time investor running my portfolio from peaceful Leicestershire countryside. I also happen to be UK´s best selling investment book author and a Financial Times Best selling author.
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