What is a balance sheet? 

The balance sheet is important because it tells investors how much the company has in assets (e.g., cash and property) and liabilities (e.g., how much money it owes to vendors, banks, and bondholders).

Like your net worth, balance sheets are only for a specific point in time; they’re a snapshot of a company’s net worth. This is unlike the income or cash flow statements, which cover periods such as a quarter or year.

Just as you might determine your personal net worth by subtracting your liabilities from your assets, the balance sheet follows a similar formula to establish shareholders’ equity.

For all intents and purposes, shareholders’ equity is a company’s net worth. This dollar amount would be returned to shareholders if the company’s assets were liquidated and its debts settled.

8 Balance Sheet Yellow Flags

1)   Cash and Cash Equivalents Less Than Total Debt

Harold Geneen, a famous business leader who transformed ITT into an international conglomerate, once said, “The only unforgivable sin in business is to run out of cash.”

Cash gives companies flexibility. It gives them options.

Debt takes that away. It makes them fragile.

As shareholders, we want to invest in antifragile companies with enough cash to meet their financial obligations for the foreseeable future.

2)   Accounts Receivable Rising Faster Than Revenue

Accounts receivable are funds customers owe for products and services they have already received.

If accounts receivable start rising faster than revenue, it could indicate that its customers are having difficulties paying their bills.

This is especially something to watch when a company has high customer concentration or operates in a cyclical industry.

3)   Inventory Rising Faster Than Profits

Inventory refers to products the company has manufactured and is ready to sell but has not yet sold. As inventory rises, profits should generally rise too.

For instance, if a retailer opens more stores, inventory and profits should rise.

However, if inventory is rising without a commensurate increase in earnings, it could mean the company is struggling to sell the merchandise on its shelves.

4)   Short-Term and Long-Term Debt Are More Than Cash

As shareholders, we want to invest in antifragile companies with enough cash to meet their financial obligations for the foreseeable future.

5)   Goodwill More Than 50% of Total Assets

Goodwill is the premium that one company pays to acquire another company.

If goodwill is over 50%, it usually means a company is buying growth and could have difficulty growing organically (e.g., through its existing products and services).

6)   Intangible Assets More Than 50% of Total Assets

Investors should want a company’s balance sheet to be loaded with liquid or usable assets, such as cash, factories, and property.

Companies with primarily intangible assets can have assets, such as goodwill, that cannot be used to capture future returns.

7)   The Presence of Preferred Stock

Preferred stock is a class of stock with a higher claim to dividends and asset payouts than common stock shareholders.

There are some benefits, but it is often more expensive than debt, and preferred stock shareholders are ahead of common stock shareholders for any rewards, such as dividends.

8)   Negative Retained Earnings

Retained earnings are the cumulative profits companies have generated since their founding (minus losses, dividends, and share buybacks).

When this number is negative, it could show that a company is unprofitable.

What to do when you see a Yellow Flag

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It’s important to note that these are yellow flags, representing caution.

They are not necessary signals to sell or avoid stocks that exhibit these flags.

When you’re driving your car, and the dashboard’s check engine light flashes on, do you immediately go to the dealership and trade your vehicle in? No, of course not!

You take it to a mechanic, or if you know how to work on cars, pop the hood up and look things over yourself.

In the same way, the balance sheet’s yellow flags represent caution, a signal that more investigation is required, but are not, in and of themselves, an immediate reason to sell a stock.

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Exceptions to every rule

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In fact, in some cases, shareholders were rewarded considerably for holding through these yellow flags.

For example, Home Depot has negative retained earnings. But once you investigate the matter further, you realize it’s only because the home improvement giant has been aggressively buying back stock and paying dividends for years.

Because both of these things reduce retained earnings, Home Depot’s retained earnings have gone negative.

There can also be good reasons for companies to hold less cash than debt, issue preferred stock, show rising inventories, or have many intangible assets.

Accounting is the language of business, but it’s a language of nuance and subtlety. The primary takeaway of any of these yellow flags spotted on a company’s balance sheet is that more investigation is required.

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