Balance Sheet Analysis: Introduction

This is Part 1 of an ongoing series on balance sheet analysis. In distressed debt investing, solid balance sheet analysis is critical to producing outsized returns. In "Margin of Safety," Seth Klarman writes: 

"Investors in financially distressed and bankrupt securities must concentrate on the corporate balance sheet. Like knowing the opposing lineups at a baseball game, understanding the amounts and priorities of a company's liabilities can tell investors a great deal not only about how the various security holders are likely to be treated but also how the financial distress is likely to be resolved.

The first step is to value the assets of the debtor. Once the size of the pie is known, it is possible to consider how it may be divided. To facilitate this process, an investor must divide the debtor's assets into two parts: the assets of the ongoing business; and the assets available for distribution to creditors upon reorganization, such as excess cash, assets held for sale, and investment securities.

...Analysis of the assets and liabilities of financially distressed or bankrupt companies must extend beyond the balance sheet however. Off-balance-sheet assets may include real estate carried below current value, an over funded pension plan, patents owned, and the like. Off-balance-sheet liabilities may include underfunded pension plans, Internal Revenue Service, Environmental Protection Agency, Pension Benefit Guaranty Corporation (PBGC), and other governmental claims, and claims resulting from rejected executory contracts and leases..."

For those interested, in future posts we will do a chapter by chapter breakdown of "Margin of Safety." - especially a break down of the chapter of Distressed Debt Investing.  Currently another value investing blog I follow: Barel Karsan is doing a review of the book.  

I generally do a balance sheet analysis for all companies I am considering an investment.  Even companies not in financial distress. Sometimes a company, with a large, long-lasting competitive advantage (a moat), will be generating a Return on Invested Capital or a Return on Equity greater than its cost of capital. In such a situation, the company should trade at a premium to book value.  For this type of situation, a balance sheet analysis like the one I am about to describe may not be appropriate.  A more useful use of time would be evaluating the strength and duration of the competitive advantage.

Nonetheless, since on this blog we are interested in distressed debt investing, we will be detailing our forensic balance sheet approach. This approach can be used in either a liquidation or restructuring scenario. It can also be used in situations where a company's equity is trading below its net current asset value as detailed by Benjamin Graham. My favorite blog on the web currently is Greenbackd, a blog specifically dedicated to undervalued asset situations with a catalyst - for those new to liquidation scenarios, start here.

Continuing with more Seth Klarman:

"Investing in bankrupt securities differs from investing in companies operating normally. An obvious difference is that in a solvent company, an investor can be relatively certain of what belongs to whom. In a bankruptcy the treatment of valid claims is precisely what is to be decided in court: the disposition of the assets is to be determined by the owners of the liabilities who, along with the equity owners, will receive the assets either directly or more typically in the form of newly issued securities of the reorganized debtor.

...One attractive feature of bankruptcy investing is that the reorganization process can serve as a catalyst for realizing underlying value. An undervalued stock may remain cheap forever and an attractive bond may have to be held until a distant maturity date to pay off, but a bankrupt company will typically reorganize within two or three years of filing under Chapter 11. Upon emergence from bankruptcy, the firm's creditors typically exchange their claims for some combination of cash, new debt securities, and equity in the reorganized debt."

As Seth Klarman noted above, the bankruptcy process and the filing of bankruptcy proceedings acts as a catalyst. As noted in one of our Distressed Debt Investing example Idearc's bank debt increased nearly 10 points from right before the filing to a week after the filing.  That is a 33% return in a very short period of time.  Another point that Seth Klarman makes is that lenders may also receive equity of the debtor following the bankruptcy.  In the hedge fund world, we call these "Post Re-Org" equities.  Many of these are publicly traded.  Doing a search on Capital IQ, examples include Calpine, Joy Global, Leap Wireless, Owens Corning, Federal-Mogul, Winn-Dixie, etc.  Post Re-Org equities can be lucrative at the right time in the cycle.  We plan to do significant amount of analysis on post-re org equities on this blog.

So to me, the exercise of evaluating distressed debt or liquidation situations is such:

1. Determine the value of the assets
2. Determine the value of the liabilities
3. Determine who gets paid first
4. Determine which security in the capital structure offers the highest risk adjusted return with the largest margin of safety

In the next section in this balance sheet analysis series, we will start right at the top of the balance sheet: with cash.