In this lesson, we're going to turn our attention to the balance sheet, also known as the statement of financial position under an international accounting standards. The balance sheet shows what we own and what we owe at a specific moment in time. Let's return to Home Depot and look at their balance sheet to see what stories we can uncover here. One of the first places to start is to see whether the company has any cash. If it doesn't, it likely has bank indebtedness under the current liability section below. Some companies like Microsoft and Apple have huge stores of cash on the balance sheet.

Many others have none at all. For those with little or no cash, the concern is liquidity that is having sufficient cash to pay bills as they come due. And what are the bills we need to be concerned with? Well, obviously we have employees and suppliers that are top of mind, but you can't forget to consider the funded debt obligations. These are the ones that can really get you into trouble. If you miss a payment, in fact, the biggest risk for many companies is refinancing large debt balances on maturity or upon a breach of a lending covenant.

So you've got to read the financial statements carefully to see whether or not this is a concern. liquidity is discussed specifically in the mdna. Let's just take a look. And here you find your liquidity and capital resources discussion, we returned to the balance sheet though, we should still be able to piece together this liquidity story without having to read the mdna. To begin with, let's look at a simple current ratio that is the current assets divided by the current liabilities. Now the way to interpret a current ratio is that if it's less than one, that might be an indication of a looming liquidity issue, but not always.

So for example, cash based businesses like hotels and restaurants have limited inventory and receivables and consequently a seemingly weak current ratio. But generally speaking, we like to see current ratios above one to one and ideally closer to two to one. A variation of the current ratio is the quick ratio is calculated the same way only it excludes inventory from current assets as inventories typically higher to liquidate our short notice. Again, the results give us one more indication of liquidity strength. Next, we should look at our debt maturity profile. The current portion of debt repayments often shows as a current liability already, but you can also refer to the notes to the financial statements to understand when major debt arrangements mature.

This is particularly troublesome in recent years is refinancing existing debt has not been easy to achieve in many businesses. Now that we have a sense of the short term liquidity position let's look more broadly at liquidity and long term context. Now financial leverage occurs when a company uses other people's money in the form of debt instruments to finance the business. My boss was always fond of the expression debt is like a double edged sword and equity is like a soft pillow. And when you sleep at night, you'd rather sleep with a pillow than a sword. What this means is that when times are good and sales are rising using other people's money can be very profitable and increase your return on equity as we have discussed in previous lessons.

However, when sales soften, having debt can quickly overwhelm you, if you aren't able to sustain the payments or meet the financial covenants. having lots of equity in a company, on the other hand, is far more conservative. From a liquidity standpoint, your shareholders can't put you out of business the same way the bank can. So what's the right answer? Well, there's a lot of theoretical justification for having some level of debt in the finance structure. Using debt lowers your overall cost of capital, which makes your company more competitive.

For example, a company With the lowest cost of capital is able to acquire strategic targets more readily than a company with a higher cost of capital. The trick is finding the right amount of debt, which can be described notionally as an amount that balances the desire to minimize the cost of capital with the financial risk associated with default. To complicate matters, every business is different. For instance, utilities are regulated businesses that generate a very stable return in the interest of minimizing the cost of capital and hence the electric rates that citizens pay. Regulators require the utility companies to carry debt in the range of 50 to 70% of their total balance sheet. At the other extreme end of the spectrum, a commodity based mining company may not use any debt given the high cyclicality of the industry and the volatility of the underlying commodity prices.

Let's look at a couple of reasons To help us uncover the debt leverage story. First we have the capitalization ratio and this ratio is calculated as the funded debt divided by the capital employed where the funded debt is a combination of your short and long term debt that has formal repayment terms associated with it and your capital employed is your funded debt plus your shareholders equity, a capitalization ratio of 75% or more would be considered high 40 to 60% is common for your large mature well established companies. Typically, all your other types of businesses are going to have capitalization ratios less than 40%. A similar sort of ratio is the debt to equity ratio, and this ratio is calculated by dividing your total liabilities by your total equity. It would be rare to see a healthy company with a ratio of more than three to one, and a more comfortable for ratio for many companies is more in the one to one range.

This ratio is often referenced by bank In the financial covenants, and finally, a common leverage ratio used by the investment banks to determine the amount and the availability of the lending facility is the funded debt to EBITDA ratio. And generally speaking, the secured lenders will make debt financing available based on a multiple of the companies even though the upper end of these facilities is typically around the two times EBITDA. This is a common ratio that gets included in lending agreements and often is used to determine the amount of available credit under the facility. Now that we have a sense of how much debt we should have on the balance sheet, we need to evaluate how well the company is able to service that debt. The two ratios that are common here are the times interest earned and the debt service coverage ratio times interest earned is calculated as your earnings before interest in taxes divided by your interest expense monitoring this ratio can help identify when a company's nearing the point of financial distress.

Generally speaking, an interest coverage ratio of less than 1.5 is considered dangerous. A healthy ratio would be five times or higher for a strong stable cash flow positive company. debt service coverage ratio is similar. However, in the denominator we also include the principal repayments. So there you have it, a pretty comprehensive look at this issue of evaluating liquidity and financial leverage. But we are finished looking at the balance sheet just yet.

As we move below current assets, you will find capital assets tangible assets are your property, plant and equipment. These types of assets can be financed with debt instruments, at least in part, and below that you find intangible assets. intangible assets are something like a patent a trademark a customer list, a brand Or it may be goodwill. goodwill is only recorded on the balance sheet. If the company has acquired another company for more than the fair value of the assets that were identified the tangible assets that is during the acquisition, internally generated goodwill is never recorded on the balance sheet. The importance of taking notice of intangible assets is that these sorts of assets cannot be financed with anything other than equity.

Many analysts will take the value of intangible assets and immediately subtract them from the book value of equity. The logic for doing this is that the intangible assets are not liquid, they only remain assets in an accounting sense, so long as the company is able to continue generating excess cash flow to substantiate their value. It's a very common to see companies writing down intangible assets after a bad year, or when they have just completed an acquisition. Let's move on to the liability section of the balance sheet. And in this section, accounts payable is an important and free source of financing for the company. The same way our customers do whatever they can to delay paying us we should be thinking the same thing.

And we can calculate and compare the days payable outstanding. Of course, you can only do so to the extent that it does not hurt the relationship with the supplier. There are lots of different types of liabilities. Some are monetary, others are estimates. Estimates include warranties accruals environmental cleanup commitments, the timing of some of these estimates is subject to considerable judgment. Also, we need to look out for any mezzanine sorts of financing.

Mezzanine financing is a layer of financing between the senior debt and the equity. Senior debt is the secured lending mezzanine. financing is normally unsecured lending. Not only is the coupon interest rate higher on mezzanine financing, very often there are equity features to consider as well, such as Equity Conversion rights, or detachable warrants. These instruments will be factored into your diluted earnings per share calculation that we saw on the income statement. But for any other analysis, you will have to go back to the notes to the financial statements to learn about the terms of these instruments.

Notice that the Home Depot does not appear to have any mezzanine types of financing. Finally, you should be aware that not all liabilities get recorded on the balance sheet there may be contingencies, commitments, guarantees and leases to consider. Again, this information is in the notes to the financial statements. There. residual leftover after we looked at the assets and removed off the liabilities is shareholders equity. Often, there is a separate statement that details the activities that happened in the shareholders equity accounts during the year.

The accounting can get a little crazy for some of these transactions, but in short, net income increases your retained earnings and dividends reduces your retained earnings. other comprehensive income exists largely to record holding gains and losses associated with balance sheet items that have yet to be recognized through the income statement. Stuff like hedging gains and losses, investment holding gains and losses, foreign subsidiary translation gain and losses. These only get recorded through the income once the instrument is unwound, sold or impaired common shares and paid in capital will fluctuate from activities such as the new issuance of shares for private placements, new issues and exercising of stock options, these accounts will decrease from the repurchase of company shares through the open market transactions or other company initiated bids. At the end of the day, it really is the net amount of shareholders equity that is most important, once again in the same way that the dollar amount of net earnings had a limited meaning.

The same could be said about the dollar amount of equity. What is more relevant to know is how much equity balance is attributable to each share. From the disclosures on the statement, we can see that there's 1.7 billion shares outstanding as of the year end date or January 30. And we can now convert the shareholders equity balance into a net book value per share number, you can subtract the intangible assets to get a tangible net book value per share. Which you can interpret as the value of the shares of the company. If it had to be liquidated today.

We'll see this metric again when we perform the investment analysis. So there you have it, the balance sheet story. The Home Depot has a strong balance, a fairly conservative financing structure and adequate liquidity. Until next time, don't stop to get to the top when you get to the top. Don't stop