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Wise investors – watch on cash & debts of company

Posted on: January 17, 2009


cash-in-hand-by-motorpurr-on-photobucketDES MOINES, Iowa – In the middle of a deep recession, corporate America is just like the rest of us: We all want cash in our pockets.

Since many companies are struggling to manage cash and debt, it’s as important as ever for investors to look closely at company balance sheets for indications of financial strength.

“The balance sheet is becoming more critical as a diagnostic tool because of what’s happening in the economy,” said Dave Ellison, president of Arlington, Va.-based FBR Fund Advisers Inc. and chief investment officer of FBR Equity Funds.

A balance sheet provides important details about a company’s assets, liabilities and shareholder equity. When reviewed with income statements – documents filed quarterly and annually that show sales, expenses and its profit – an investor can gather get a sense for a company’s overall financial health.

One lesson learned from the recession is that companies can build balance sheets that on the surface look healthy but are fraught with overvalued assets and too much debt, Ellison said.

“That’s what you’re seeing in part of this recession – a lot of people and a lot of companies that don’t have balance sheets to survive the downturn,” he said. “They built their business for a perfect economy and they did it with big debt.”

Ellison’s advice is to look at a company’s level of cash, net of debt – in other words, all of the money the company has on hand excluding what it owes.

Companies managing cash wisely are the ones more likely to emerge stronger when the economy recovers and will be poised to capture market share from weaker competitors, said Eric Cinnamond, a Jacksonville Beach, Fla.-based manager of Intrepid Small Cap Fund. He said he uses cash flow and level of debt as significant indicators of company value.

Company executives who keep debt low have much more flexibility to run the business because they’re not restrained to using cash just to service debt.

“They can make better decisions, they’re not tied to Wall Street and they’re not at the mercy of the banker,” he said. “It just gives them a lot of independence.”

As the economy weakened, companies with abundant cash and little need to borrow were in a much better position than those that had burned through their cash by buying back stock or borrowing money to expand.

An example of a good cash manager is Chicago-based Oil-Dri Corp. of America, the leading supplier of cat litter, Cinnamond said.

It’s one of the largest holdings in his fund, which has outperformed the S&P 500 by nearly 16 percent over three years and by nearly 4 percent his year. Currently, the fund is down 2.9 percent, Morningstar says.

Oil-Dri finished its fiscal year with $684,000 more cash than debt, the company said in its annual report. At end of the fiscal year, Oil-Dri had $27 million of debt and $88 million in equity.

The company reported 2008 earnings per share of $1.25, better than many of its peers.

The company’s stock has outperformed its industry and the S&P 500 for the last four years. Last year, although total returns – the stock price appreciation plus dividends – was down nearly 12 percent, it still outperformed its industry by 30 percent and the S&P 500 by nearly 27 percent.

Oil-Dri sells cat litter under its own private label brand to Wal-Mart and other retailers. The company has as much cash as it does debt and business grew 20 percent last year, Cinnamond said.

The shares have traded between $10.19 to $21.50 in the past 52 weeks. They closed down 20 cents to $16.03 Friday.

Morningstar.com offers a screening tool which allows investors to call up companies that meet specific criteria. A search for companies with free cash flow and with at least 5 percent of total assets in cash brings up a interest list of recognizable corporations. The list of “cash cows” includes Nestle SA, Google Inc. Oracle Corp., Apple Inc. and Bristol-Myers Squibb Co.

While looking at a company’s financial reports, you should look at footnotes, which often include important details of a company’s financial health, advises Brent Lipschultz, a CPA with New York accounting firm Eisner LLP.

In addition, investors should make sure the auditors are reputable and compare the company they’re considering to industry benchmarks to see if it measures up to others in the same business sector, Lipschultz said.

A few other questions he advises you ask to assess a company’s performance: Has a company cut dividends? Has it laid off professional staff? Are executives buying stock in the company?

All indications are the recession has driven investors to develop a heightened sensitivity to cash and debt levels.

“Companies with weak balance sheets have really been punished by the market in the last several months,” said Ira Carnahan, an equity analyst at T. Rowe Price.

He looks closely at whether a company is generating enough cash flow to cover its interest expense and at the notes attached to a company’s debt.

Loan agreements usually contain covenants, requirements that companies maintain certain capital levels.

Sometimes they’ll be disclosed in an annual report, or they’ll be referenced in the report with directions on where to look to find them.

You’ll see in this environment cases where management gets lenders to waive debt covenants. It’s a sign there could be trouble.

“You do have a lot of companies that have a fair amount of debt. If you go in with a fair amount of debt and have a sharp downturn, the combination can create problems for you very quickly,” Carnahan said.

Cinnamond said there’s another reason shareholders should be concerned about debt. They may be in line to get paid behind the company’s bank, bond holders and others, depending on the kind of debt the company owes.

“We want to be first in line to receive the free cash flow in that business,” he said. “Strong cash flow and balance sheets mean you’ll have above average dividends.”

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