3 Tricks to Read A Balance Sheet
Don’t Listen To Me, But Please, Hear Me Out: #12
July 15 2020
Last week I showed you how to quickly check 4 items in an Income Statement to get a feel for how good a company’s financial health is. This week it’s all about Balance Sheets.
To Recap, there are 3 main statements:
- Income Statement: Tells you about the profitability of the company.
- Balance Sheet: Tells you about the overall financial health of the company and if they can sustain themselves over a long period in the future.
- Cash Flow Statement: Tells you if they are able to make payroll and other expenses easily or if they have to borrow short term loans from the bank against future revenues so that they can pay their employees, vendors, utilities etc, on time.
Balance Sheet Statement
Let’s go back to our Sports Sector and look at Nike’s Balance Sheet.
Once again, I am using the Marketwatch website.
A Balance Sheet tells you what the company’s assets, liabilities, and shareholder’s equity are at a given date. I won’t go into the details of every line item in a balance sheet. Instead, I will show you how to look at a balance sheet and quickly decide if the company is healthy or if there are any red flags.
3 Tricks to a Balance Sheet
- Cash: Nike has wonderful cash balance of nearly $9 Billion which is up nearly 50% from 2019. I love companies that have a good cash balance. This means that during unprecedented events like the pandemic, they will be able to survive, meet its payment obligations such as payroll, rent, interest payments etc. Moreover, cash on hand means Nike is well positioned to buy smaller, strategic companies at bargain prices. You can look at the 2 ratios:
- Cash Growth declined in 2018 and 2019, but looks good for 2020
- Cash as a percent of Total Assets: Nike has maintained and average Cash to Asset ratio of 25% which is also good. Again, having sufficient cash means that if things go pear shaped as it has during this pandemic, a company is not forced to sell its immovable assets such as plants and equipment at a fire sale discount.
- Debt: I personally don’t like companies taking a lot of debt. Since 2009, many companies have been loading their balance sheet with debt because it was “cheap”. Interest rates were less than 1% for most of the past decade. Nike has $13 Billion in short term and long-term debt. It’s a bit higher than the $9 Billion in cash. However, if you only look at what they have to pay back in the short term which $696 Million, Nike is on very safe grounds.
- Retained Earnings (RE): This is basically the amount of profits left over after the company pays dividends to the shareholders. In other words, the amount of profits the company Retains after paying out dividend. This is important as it means the management believes the company can grow more by reinvesting the profits back into the company. It says that management believes the stock returns per share will be greater than the dividend per share over time. RE also allows a company to pay off expensive loans or debt. RE along with the Cashflow statement can tell you a lot more.
I have described everything above in a video if you’d prefer to watch it instead. But please don’t forget to read the rest of the blog, because that is where you will really learn how to compare balance sheets of two companies.
As always, it is best to compare Nike’s performance against a peer like Lululemon. So let’s do that.
Nike vs Lululemon Balance Sheet
Cash positions have swung a lot for both Nike and Lululemon although Lululemon’s strategy seems to be more consistent.
Cash as a Percent of Total Assets
Both Nike and Lululemon seems to have consistent strategy of how much Cash they will keep as a percent of total assets. Nike seems to favor Cash position of around 25% and Lululemon favors a Cash to Asset ratio of 42%.
Cash & Short-Term Investments Absolute Amount
Although Lululemon does have a higher Cash to Asset ratio, the one with more absolute cash, has unique advantages. Nike had on average $6 Billion in cash whereas Lululemon had around $840 Million. It is important to note that according to Nike’s Quarterly Financial report, cash increased due to the following:
- A $6 billion corporate bond issuance in March
- An additional $2 billion credit facility to mitigate the impact of Covid19.
Lululemon has long term Debt of $611 Million and Nike has long term debt of $12.3 Billion. Can they meet their debt obligations? We can look at Debt to Total Asset (TA) Ratio or Total Liabilities (TL) to TA ratio to answer this.
TL/TA has been steadily increasing over time for both Lululemon and Nike. Lululemon’s total liabilities are 41% of its total Assets whereas for Nike it’s 74%. The TL/TA ratio indicates how much of the company’s financing needs are funded by debt rather than equity. We want this ratio to be less than 100%. If it is greater than 100%, then that means the company may not be able to meet its debt obligations and may go bankrupt.
It is also important to note that if a large percent of the TA is made of “goodwill”, which cannot be sold for cash, then, too a company may find it difficult to meet its debt obligations. In the case of Nike and Lululemon, everything looks good as they have a large portion of their assets in cash. Lululemon has booked goodwill at $24.4M which is less than 0.75% of TA. Nike’s booked Goodwill as a percent of TA is about 0.71%.
Both Nike and Lululemon’s Retained Earnings as a percent of assets have been declining. In fact, Nike had zero RE in 2020 although it did distribute dividends. Lululemon does not distribute dividends implying that it believes that it can give shareholders higher returns through stock price gains. Lululemon expects to grow more. Recall that Nike issued Corporate Bonds for $6 Billion in March 2020 and now has a high cash position, so RE is zero.
Putting it All Together
Both Nike and Lululemon have healthy balance sheets. If you want faster growth, Lululemon could be the better bet. However, competition in Athleisure apparel is increasing. Many of the traditional retailers will explore this space as it is fastest growing sector in the apparel segment. Nike has the largest market share in athletic apparel. With the cash on hand, they can do some real damage in innovating and bringing out a new line of athleisure wear.
Now that you know how to quickly assess a balance sheet, if you had a broker or financial advisor these are the questions you should ask:
- Why did Nike’s Cash increase so much especially in the period of COVID19? What implications does it have?
- Why did Nike have Zero Retained Earnings for 2020? Do they not plan on growing as much?
I am NOT a certified broker or financial advisor. Please DO NOT make investment decisions based solely on my blogs. My intention is to show you how to research stocks or funds for yourself so you can feel empowered and knowledgeable to do your own investigations and invest with confidence. It is best to consult with your broker or advisor if you have questions. You can also reach me and I’ll do my best to help you with your queries.