The best stocks tick these 3 boxes on the balance sheet | Company

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(Mark in white)

Investment research can be very exciting when you watch visionary founders pitch their companies or witness the magic of innovative new products. But when it comes to looking at balance sheets, most investors are wide-eyed.

Few people would classify studying balance sheets as fun, but understanding this financial statement is extremely important. Even the most disruptive companies won’t last long as public companies if they have weak balance sheets.

Below are three important indicators that I look for in determining the strength of a company’s balance sheet.

Image source: Getty Images.

Note: If you are new to balance sheets, read: “How to read a balance sheet” before proceeding.

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1. Healthy Current Report

The first thing I look for in a company’s balance sheet is the ratio of current assets to current liabilities, also known as the current ratio.

Current assets are all assets that are in cash or can be converted into cash within one year. On the other hand, current liabilities are obligations that the company has to repay within a year.

A current ratio below 1 means that the company has more short-term obligations than it has cash on its balance sheet. A current ratio greater than 1 means that the company will be able to meet its short-term commitments.

Here are some examples of current assets:

  • Cash equivalents – money market funds, short-term treasury bills, etc.
  • Marketable securities – investments such as stocks or bonds.
  • Accounts Receivable – money owed to the business by customers within 12 months.

Current liabilities would include categories such as:

  • Leases.
  • Short term debt.
  • Accounts Payable (money the business owes suppliers or vendors within 12 months).

Now let’s review the actual ratio of a real business. Below is an excerpt from the Health Technology Checkup Doximity (NYSE: DOCS) from December 2021.

This company has significantly more current assets than current liabilities at $858.3 million versus $91.7 million. This gives an impressive current ratio of 9.4. Since this number is well above 1, Doximity will have no problem covering its current liabilities in 2022. If you want to be more conservative, you can only look at its truly liquid assets, which would be cash and cash equivalents. cash and negotiable securities. Even then, the ratio comes out at 8.3.

Companies with current ratios below 1 will need to tap into additional resources (either by taking on long-term debt or issuing more equity) to avoid bankruptcy. A low current ratio does not necessarily mean the company is in trouble, but investors will need to examine the company’s debt structure to better understand the financials.

In Doximity’s case, it has a very high current ratio and zero debt, so it’s safe to say that unless something catastrophic happens, this company isn’t going bankrupt anytime soon.

2. Limited “soft” assets

When looking at total assets on the balance sheet, you might be confused by categories such as intangible assets or goodwill. These are known as soft assets, and if they represent a significant portion of the company’s total assets, investors should sound the alarm.

Intangible assets are things like brand equity or intellectual property. They must be recognized on the balance sheet, but these assets cannot be easily converted into cash, if at all. If there is an overrepresentation of intangibles in the asset column, you need to research more information to understand why the company believes its intangibles are worth so much.

Good will is an intangible asset that is created when a company makes an acquisition and pays a higher price than the fair market value (FMV) for the company. The difference between the price paid and the FMV theoretically represents the value of all the intangible assets of the acquired company.

Doximity has about $18 million in goodwill, meaning it paid an $18 million premium for intangible assets from its recent acquisitions.

It is normal for a company to pay a premium on an acquisition, so there is no reason to be automatically alarmed. But if goodwill represents a large share of total assets, it could indicate that the company has greatly overpaid for its recent purchases.

In the balance sheet example above, Doximity’s goodwill and intangible assets are very small compared to the total assets, so nothing too worrying.

The main conclusion is that intangible assets are difficult to value. So, if the company counts a large portion of its total assets as intangible, it could be a sign of a weak balance sheet.

3. Financial Health History

A balance sheet is a snapshot of a company’s financial health at a given time. Thus, it does not tell us how the company’s finances have changed over time. To find out, investors should look at past balance sheets and compare.

The table below presents Doximity’s current assets and liabilities for the last four quarters.

March 2021

Current assets:

$209 billion

Current liabilities:

$102 billion

June 2021

Current assets:

$790 billion

Current liabilities:

$100 billion

September 2021

Current assets:

$830 billion

Current liabilities:

$96 billion

December 2021

Current assets:

$858 billion

Current liabilities:

$92 billion

With the context of three more quarters of balance sheet data, you can see that Doximity is steadily improving its financials. It’s even better to have more than three-quarters of the data to work with, but since Doximity went public in 2021, that’s all reported data that investors have access to.

However, it is the sign of a very solid company financially.

The key to becoming a better investor

It is by no means an all-encompassing method of analyzing balance sheets, but looking at these three indicators provides a quick understanding of a company’s overall financial health.

And while reading balance sheets might not be the most fun part of investing, it makes you a better investor with each one you study.

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Mark in white has no position in the stocks mentioned. The Motley Fool holds positions and recommends Doximity, Inc. The Motley Fool has a disclosure policy.

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