Episode 9 | Balance Sheet within the GWII BMPB Investment Framework

In Episode 9 of "Market News with Rodney Lake," Rodney Lake, the Director of the GW Investment Institute, delves into the intricacies of assessing a company's balance sheet as part of the GWII BMPB Investment Framework. Focusing on companies like Apple and Procter & Gamble, Professor Lake illustrates the impact of financial health on investment decisions, emphasizing the importance of asset and liability matching. He explains how Apple’s strong position with nearly $60 billion in net cash allows it to navigate challenging market conditions, contrasting this with Procter & Gamble’s steady cash flow from its consistent product demand. This contrast provides valuable insight into the different financial strategies adopted by these companies. Tune in to learn more!

Transcript

Thank you for joining “Market News with Rodney Lake.” This is a regular show of the G.W. Investment Institute where we discuss timely market topics. I'm Rodney Lake, I serve as vice dean for undergraduate programs at George Washington University School of Business. Let's get started. Welcome back to “Market News with Rodney Lake.” Today is episode nine. We are here at the Duquès’ Family studio.

Thanks again to the Duquès family. Today we're going to be wrapping up the BMP framework for this version. Today is the balance sheet. So it's the last B in that piece and we're going to go through the balance sheet. We're going to have an example. Today is the same example we use in the prior episode. We're going to stick with Apple just in case you just heard the last episode.

We'll stick with the same company again large holding in our portfolio but also a recognizable company. So probably you have all heard about Apple again, the framework, business management, price valuation and balance sheet. We've used this framework at the Investment Institute for 20 years, and it's worked for us. And our students have been able to outperform the market over time with this framework.

We're happy to share it with you. And if you're looking to be a better investor, if we're if you're looking to be a better analyst, we hope this is helpful for you. A reminder and disclaimer that this is not investment advice, and you should consult a professional to do so. And this is all for educational purposes and for the investment institute.

So I hope you've all heard about the balance sheet. And if you haven't, it's one of the primary financial documents that companies are required to file with the Securities and Exchange Commission of their publicly traded companies. And even if you're not a publicly traded company, you're going to want to have something that's called a balance sheet to understand what are the assets and liabilities and owner's equity for your company.

So understanding the balance sheet, not from the accounting point of view, is what we're going to tackle today. Understanding it from an analyst point of view, when you're looking at a company and whether you should be comfortable with the balance sheet or uncomfortable, and there's a lot more work to do when you talk about financial statement analysis and accounting.

That's not what we're tackling with this. What we're tackling here is, as an analyst, do we think that there's a lot of risk in the balance sheet or there's not a lot of risk? And how can we understand that and how can we do that fairly quickly? Well, the techniques that we use at the investment Institute help to get you through that fairly quickly.

Now you have to have some basic understanding of accounting. So if you don't, you have to sharpen yourself on that a little bit first. But you don't necessarily have to have it really full stack, but you have to have a little bit of it. So should you have confidence? Should you not have confidence in the balance sheet and why or why not?

So that's really the question when we're thinking about the BNP framework. And as a reminder, we score 1 to 10, 10 being the best and one being, you know, kind of a disaster, not something you would want to get involved in in a ten. And the case of a balance sheet is a balance sheet that helps you sleep at night.

So let's get into you know, Apple as our example. So when we talk about companies and that's all we really talk about in market news, obviously at the Investment Institute it's a company. So we're looking at the balance sheet with a particular company. That's the lens that we have. So when we're thinking about a specific company, we're thinking, okay, well what are what's the really the debt.

Right. So when we're looking at the balance sheet as an analyst, we're really thinking about, okay, what's the primary risk, for any company, the top risk for any company is going out of business or bankruptcy. And the more that you increase the debt on a business, the higher that you ratchet up the probability that it gets into a default situation and that the investment Institute and I remind our students, analysts of this all the time, we're equity holders, we don't own fixed income.

We're equity holders. So in most cases equity gets wiped out in a bankruptcy. There are different types of bankruptcies. And that's for another day to, but for the most part, you can think about it, that the risk of going through bankruptcy for a common shareholder, in equity is probably ends up being zero, meaning that you get wiped out.

You're not going to get any recovery, or very likely not to get any recovery. So in your mind, and when you're analyzing, you should be thinking about, okay, well, if this company is heading towards bankruptcy, maybe it's time for me to move on. Or if I haven't purchased the company yet, maybe it's time for me to pass it on this company and say, you know, not for us, certainly not for the investment institute.

And what we try to tell students is we want to stay away from companies, that we think are are in trouble or likely to be in trouble. So we're looking for strong balance sheets. We're looking for a company, that has really, you know, a lot of strength, there and making sure that it's prepared for a difficult time.

And we can always predict. And we talked about, you know, these management teams being prepared. Well, one indicator that we mentioned is what's the strength of the balance sheet. Who's in control of the balance sheet. The management team. Right. and the board on top of them. But the management team is in charge of managing the balance sheet.

So if they've really run their cash down, and they have a lot of debt and they're having trouble paying their bills, well, is that a good situation to be in? Not for equity holders. Right. So you want to have a responsible management team that's managing the risk on the balance sheet. So then how do we understand if they're doing that?

Well, a couple of things. Number one you should look back through time and see how they managed in very stressful periods. So look at the financial crisis in 2008. Look at during Covid. What did the management team do? Were they ill prepared for that? So in the great financial crisis, if it's the same management team, if they did a good job, it's probably the same management team.

and if not, it could be, you know, a different management team, but try to check track, check whether where they were at that time, if possible, if they're a CEO somewhere else. As an example. But how did this company move its way through that, that period? And how did they manage through another difficult period, either for the company or generally.

So generally another one would be obviously Covid. How did they manage through that period as well? Were they prepared that they have a lot of net cash going into those situations where they were going to survive almost no matter what now, unless the world really ends? So if that's the case, well, that's a strong balance sheet that helps you sleep at night.

And it also allows that management team and that company to be aggressive during those time periods. So while other companies are not prepared and have weak balance sheets, these companies can use their strong balance sheets to go out and acquire market share. As an example, by buying other companies or discounting prices, such that they pick up market share as a result.

Meanwhile, their competitors are in a very challenging position and cannot do that, and which means they lose market share. Well, you have to have a strong balance sheet because maybe you have to subsidize some of that price cuts. Well, if you have that cash ready and you can subsidize those price cuts as an example, and that means you end up with more market share, and then you can steadily raise prices later after, the competitors are either weakened, you know, to the point of going out of business or weakened, so such that they can't compete.

Well, that's a net advantage for the company that's in that strong position. And so you want to be thinking about companies that can do that. You want to be thinking about, a strong balance sheet, as a precursor for a purchase into a company. So but what does that mean? How do we figure that out? Let's say we don't have a lot of accounting, in our background, how can we quickly figure out a company's, strong or weak with that?

Well, one ratio is, the interest coverage ratio. And that's just the earnings before interest and taxes. EBIT over interest. You know, the higher that number is, the better we can sleep at night. if the number is really low, you should definitely be concerned that the equity you want that to be a manageable number. And the quick ratio is talks about the liquidity in the company.

What we're really going to tackle, today is really just the interest coverage ratio. and really what's something called net cash. in our example. So this is data from Bloomberg. So if you talk about Apple, currently, mid-July here in 2024, the times interest earned or the interest coverage ratio for Apple is about 29 times.

That's very good. We can sleep at night. We're not worried about that. And then when we look at what's the net cash or net debt for Apple, they actually have a net cash position. So when you look at the end of the third quarter or end of the calendar year, first quarter, March 30th, apples, cash and cash equivalents sit at $162 billion, which is, very good.

and their total debt is 105 billion. So their net cash position is just simply the the cash and cash equivalents, minus, the total debt that gives you 57 billion approximately. And net cash. Well, that definitely helps you sleep at night. That net cash position can be used for flexibility, again, to do Here is the text with the timestamps and the word "unknown" removed:

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Different things. If there's some challenging market period ahead of us, Apple is going to be in a strength position because it has nearly $60 billion in net cash.

And by the way, it can tap the debt markets because it has a good credit rating. If a company is not in that situation, you have to ask yourself, why is it not in that situation? And is it manageable? Another company to use as a comparison that might have a lot more debt would be, let's say, Procter and Gamble.

But Procter and Gamble generates a lot of cash flow because of the type of business it's in. Right? It sells lots of products that people buy consistently. And people buy those products like toothpaste. Whether the market is good, the market is bad, people tend to want to brush their teeth as an example. So they could probably have their debt a little bit higher than another company and still be okay because the demand for their products really goes through cycles.

Compare that to, let's say, if you have a commodity business, and let's say it's ratcheting up its debt really high. So unlike Apple, it doesn't have net cash. It has net debt. Well, what happens to commodity prices? They typically go up and down. They move in cycles, and over long periods of time, commodities tend to go lower.

But sometimes there's boom and there are bust periods. And so if it's in a boom period and things all look great, but the company's taking on excessive amounts of debt, well, you should be concerned possibly about that company from the investment perspective because if the cycle turns, the interest coverage ratio is going to look really good, and then it's going to look really bad and potentially into bankruptcy.

So when you match the cycle, which is up and down, with debt that's increasing, that's a problem. And what we call that is asset versus liability matching. The asset is the company in their ability to generate cash flow. If it's a commoditized business and their ability to generate cash flow is tied to the price of a specific commodity or a basket of commodities that tend to move together, they're highly correlated.

And let's say they move with the market and the economics, a cyclical business. Well, then when it's a difficult period, that's going to be a big challenge to pay the interest on that debt and to pay the debt back ultimately. So that can be an asset liability mismatch. And as an analyst, you're looking for that. You want asset liability matching. Meaning, for example, if Procter and Gamble has debt out there, but they have consistent cash flow because people want to buy their toothpaste through any cycle, that's great.

But if there is a disconnect there, if there is an asset liability mismatch, you need to identify that as an analyst and think, well, this company is a cyclical company, meaning that it's a commoditized company that moves with the cycle. Or it can be—it doesn't only have to be a commoditized company, but the example here is a commoditized company that moves with the cycle, and it has a lot of debt and increasing for whatever reason.

Maybe they're trying to acquire other companies during this period. Well, if the situation turns and the commodity prices start to tail off or drop dramatically for whatever reason, that company can be in a world of pain because they cannot service the debt and pay the debt back. Well, that can mean bankruptcy. And as an equity shareholder, that's a huge risk.

That's our ultimate risk for any business is to go out of business. So as a company, you know, when you can see the net cash, as the example we used in Apple, that's fantastic. That's the kind of setup that we want. We want to be in the net cash position for the most part. It doesn't mean that you don't invest in other companies and you look at other companies, but that's the preference.

Now, as we've talked about before, you don't have to invest in all companies. You don't have to invest in a commoditized company if you don't want to, it's up to you. You can if you want to; you don't have to. The preference for the investment institute is for us to invest in high-quality companies that are great businesses that have fantastic management teams, that have fair valuations, and very strong balance sheets because we know we're investing for the long term.

We want to make sure that whether it's this year, next year, five years from now, ten years from now, that we're in good shape. It's an endowment fund that these funds are invested as. And so that runs in perpetuity. So we're thinking long term; we're trying to say, well, what's going to happen next year, five years, ten years from now.

And how can we make sure as analysts that this company is ready? Well, the strength in the balance sheet is a great indicator for that. And it's a great indicator about the risk that the management's really taking with the company. If they're being irresponsible, it could mean that they have this big mismatch on this asset liability mismatch.

As an analyst, you would say, well, that's really irresponsible. Maybe it pays in the short term and it looks good. The company is growing. But as an analyst, you have to think, okay, well, that is really just risk in the business. It just hasn't shown up yet because the cycle hasn't turned yet. But when the cycle turns, and we don't necessarily know when that might be, that's a big risk for the company.

So again, for the types of companies that the investment institute is interested in and investing in and owning and holding, they have a very strong balance sheet or a balance sheet that we can understand and appreciate that management is aligned with us. On the risk side, we want high risk-adjusted returns, so we want to make sure that the balance sheet shows strength and shows that through.

Ideally a net cash position. But certainly having an asset liability match. There are other metrics to look at here. But I encourage you to make sure you really look at the interest coverage ratio, also known as the times interest earned, which is EBIT (earnings before interest and tax) over interest. Look at that ratio. Look how it's changed over time.

And make sure you're comfortable with that. If it's been very consistent and consistently high, that's fantastic. If it's been high at some points and really low at others, you should really try to understand, is that the same management team in place that's been doing that? Because that would be a concern because that means likely there's been some mismatches between asset and liability.

So think about it. Look at this over time. The balance sheet is a snapshot in time. But you should be looking at these balance sheets over time. And how has the company managed those balance sheets over time? The balance sheet is a reflection of how management is running the business. The risks that they're willing to put in the business because it is how they finance the business.

It's the assets, the liabilities, and the owner's equity in the business. And you as an analyst, and especially you guys at the investments too, when we're thinking about being equity shareholders, we have to think about what is the risk. The balance sheet helps us start to understand what's the risk in the financing of the business. It doesn't necessarily say anything about what's the risk of the business itself.

That's in the business part of our equation in the first B, not in the last B. But we really try to understand what's the financing risk of the business. How has management set this up? What's the asset? What's the liability? What's the owner's equity? How has this management team organized the financing of this company?

You can also use credit ratings. And so the major agencies out there, Moody's and S&P. And look at that. You know, there have been periods where maybe, you know, they've been difficult to understand. However, they can be very useful. So you should do your own work. Look at the credit ratings for these companies. If they issue debt, if they don't issue debt, then they're very likely, and they have net cash, then that's something you don't necessarily have to worry about.

And sometimes, again, when you have net cash, in the example of Apple, it's a pretty quick analysis. It's not something you have to spend a lot of time on. But it is something that you should be spending time on over time. And you should be doing this on a consistent basis as an analyst, making sure that you update on a regular basis if things change, if the market changes, that you're understanding this as an analyst.

So for the balance sheet, it's a much more straightforward setup than understanding the business or understanding the management team or certainly understanding the price versus the valuation. But it is important work. And it's important for you as an analyst to understand the financial risk that a company has. And it's important for you. And it's a window into how management views risk and financial risk and how what they're willing to do or not do.

And it's very helpful. So you should learn it, you should understand it. And it's going to help every time, your understanding of a company. So make sure you add it as part of your framework. So it's the BMP. It's the balance sheet here at the end. Thank you for watching. And we'll be back on the next episode.

See you then.

Disclaimer: The content shared in the GW Investment Institute podcast is for informational and educational purposes only, and should not be considered investment advice. The opinions expressed in this podcast are those of the host and guest, and do not necessarily reflect the views of the GW Investment Institute or the George Washington University. Listeners should not act upon the information provided without seeking professional advice from a qualified financial advisor.

Investing involves risks including the loss of principal. The GW Investment Institute. The George Washington University. In the podcast, hosts do not assume any responsibility for any investment decisions made different things. If there's some challenging market period ahead of us, Apple is going to be in a strength position because it has nearly $60 billion in net cash.

And by the way, it can tap the debt markets because it has a good credit rating. If a company is not in that situation, you have to ask yourself, why is it not in that situation? And is it manageable? Another company to use as a comparison that might have a lot more debt would be, let's say, Procter and Gamble.

But Procter and Gamble generates a lot of cash flow because of the type of business it's in. Right? It sells lots of products that people buy consistently. And people buy those products like toothpaste. Whether the market is good, the market is bad, people tend to want to brush their teeth as an example. So they could probably have their debt a little bit higher than another company and still be okay because the demand for their products really goes through cycles.

Compare that to, let's say, if you have a commodity business, and let's say it's ratcheting up its debt really high. So unlike Apple, it doesn't have net cash. It has net debt. Well, what happens to commodity prices? They typically go up and down. They move in cycles, and over long periods of time, commodities tend to go lower.

But sometimes there's boom and there are bust periods. And so if it's in a boom period and things all look great, but the company's taking on excessive amounts of debt, well, you should be concerned possibly about that company from the investment perspective because if the cycle turns, the interest coverage ratio is going to look really good, and then it's going to look really bad and potentially into bankruptcy.

So when you match the cycle, which is up and down, with debt that's increasing, that's a problem. And what we call that is asset versus liability matching. The asset is the company in their ability to generate cash flow. If it's a commoditized business and their ability to generate cash flow is tied to the price of a specific commodity or a basket of commodities that tend to move together, they're highly correlated.

And let's say they move with the market and the economics, a cyclical business. Well, then when it's a difficult period, that's going to be a big challenge to pay the interest on that debt and to pay the debt back ultimately. So that can be an asset liability mismatch. And as an analyst, you're looking for that. You want asset liability matching. Meaning, for example, if Procter and Gamble has debt out there, but they have consistent cash flow because people want to buy their toothpaste through any cycle, that's great.

But if there is a disconnect there, if there is an asset liability mismatch, you need to identify that as an analyst and think, well, this company is a cyclical company, meaning that it's a commoditized company that moves with the cycle. Or it can be—it doesn't only have to be a commoditized company, but the example here is a commoditized company that moves with the cycle, and it has a lot of debt and increasing for whatever reason.

Maybe they're trying to acquire other companies during this period. Well, if the situation turns and the commodity prices start to tail off or drop dramatically for whatever reason, that company can be in a world of pain because they cannot service the debt and pay the debt back. Well, that can mean bankruptcy. And as an equity shareholder, that's a huge risk.

That's our ultimate risk for any business is to go out of business. So as a company, you know, when you can see the net cash, as the example we used in Apple, that's fantastic. That's the kind of setup that we want. We want to be in the net cash position for the most part. It doesn't mean that you don't invest in other companies and you look at other companies, but that's the preference.

Now, as we've talked about before, you don't have to invest in all companies. You don't have to invest in a commoditized company if you don't want to, it's up to you. You can if you want to; you don't have to. The preference for the investment institute is for us to invest in high-quality companies that are great businesses that have fantastic management teams, that have fair valuations, and very strong balance sheets because we know we're investing for the long term.

We want to make sure that whether it's this year, next year, five years from now, ten years from now, that we're in good shape. It's an endowment fund that these funds are invested as. And so that runs in perpetuity. So we're thinking long term; we're trying to say, well, what's going to happen next year, five years, ten years from now.

And how can we make sure as analysts that this company is ready? Well, the strength in the balance sheet is a great indicator for that. And it's a great indicator about the risk that the management's really taking with the company. If they're being irresponsible, it could mean that they have this big mismatch on this asset liability mismatch.

As an analyst, you would say, well, that's really irresponsible. Maybe it pays in the short term and it looks good. The company is growing. But as an analyst, you have to think, okay, well, that is really just risk in the business. It just hasn't shown up yet because the cycle hasn't turned yet. But when the cycle turns, and we don't necessarily know when that might be, that's a big risk for the company.

So again, for the types of companies that the investment institute is interested in and investing in and owning and holding, they have a very strong balance sheet or a balance sheet that we can understand and appreciate that management is aligned with us. On the risk side, we want high risk-adjusted returns, so we want to make sure that the balance sheet shows strength and shows that through.

Ideally a net cash position. But certainly having an asset liability match. There are other metrics to look at here. But I encourage you to make sure you really look at the interest coverage ratio, also known as the times interest earned, which is EBIT (earnings before interest and tax) over interest. Look at that ratio. Look how it's changed over time.

And make sure you're comfortable with that. If it's been very consistent and consistently high, that's fantastic. If it's been high at some points and really low at others, you should really try to understand, is that the same management team in place that's been doing that? Because that would be a concern because that means likely there's been some mismatches between asset and liability.

So think about it. Look at this over time. The balance sheet is a snapshot in time. But you should be looking at these balance sheets over time. And how has the company managed those balance sheets over time? The balance sheet is a reflection of how management is running the business. The risks that they're willing to put in the business because it is how they finance the business.

It's the assets, the liabilities, and the owner's equity in the business. And you as an analyst, and especially you guys at the investments too, when we're thinking about being equity shareholders, we have to think about what is the risk. The balance sheet helps us start to understand what's the risk in the financing of the business. It doesn't necessarily say anything about what's the risk of the business itself.

That's in the business part of our equation in the first B, not in the last B. But we really try to understand what's the financing risk of the business. How has management set this up? What's the asset? What's the liability? What's the owner's equity? How has this management team organized the financing of this company?

You can also use credit ratings. And so the major agencies out there, Moody's and S&P. And look at that. You know, there have been periods where maybe, you know, they've been difficult to understand. However, they can be very useful. So you should do your own work. Look at the credit ratings for these companies. If they issue debt, if they don't issue debt, then they're very likely, and they have net cash, then that's something you don't necessarily have to worry about.

And sometimes, again, when you have net cash, in the example of Apple, it's a pretty quick analysis. It's not something you have to spend a lot of time on. But it is something that you should be spending time on over time. And you should be doing this on a consistent basis as an analyst, making sure that you update on a regular basis if things change, if the market changes, that you're understanding this as an analyst.

So for the balance sheet, it's a much more straightforward setup than understanding the business or understanding the management team or certainly understanding the price versus the valuation. But it is important work. And it's important for you as an analyst to understand the financial risk that a company has. And it's important for you. And it's a window into how management views risk and financial risk and how what they're willing to do or not do.

And it's very helpful. So you should learn it, you should understand it. And it's going to help every time, your understanding of a company. So make sure you add it as part of your framework. So it's the BMP. It's the balance sheet here at the end. Thank you for watching. And we'll be back on the next episode.

See you then.

Disclaimer: The content shared in the GW Investment Institute podcast is for informational and educational purposes only, and should not be considered investment advice. The opinions expressed in this podcast are those of the host and guest, and do not necessarily reflect the views of the GW Investment Institute or the George Washington University. Listeners should not act upon the information provided without seeking professional advice from a qualified financial advisor.

Investing involves risks including the loss of principal. The GW Investment Institute. The George Washington University. In the podcast, hosts do not assume any responsibility for any investment decisions made