Episode Transcript
[00:00:00] Speaker A: The markets. We just can't get enough of them.
[00:00:03] Speaker B: Markets are the drivers of your wealth and investment strategy.
[00:00:07] Speaker A: Welcome to Magic Markets with your co hosts, the finance Ghost and Mohammed Nallah.
[00:00:13] Speaker B: Together we have more than 25 years of combined experience in the markets.
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Welcome to episode 195 of Magic Markets. And we're doing another one of those how to shows. We've had some really good stuff recently. We've talked about bear cases and bull cases. We've talked about how to read an income statement. We had the guys from Ambro on talking about how to build a portfolio. So there's really been a lot of, I think, quite good, rather educational content, although I always get a bit nervous of using that word because we never want to make it sound like, you know, everything we know is right and we're trying to teach stuff. That's not what it's about. It's just our approach and how we do things. And, you know, there are many, many different approaches to taking the markets, and we hope that some of this stuff will resonate with you and maybe help you in your own process. Of course, we always welcome feedback as well. And mo today we're going to talk about another part of the suite of financials that is really important and is the reason why companies sometimes do go bankrupt or sometimes make a huge success of themselves. And that is the balance sheet, which is, at the end of the day, the fortress of your little investment, isn't it?
[00:01:48] Speaker B: Indeed, ghost? I mean, the feedback from our listeners has really been quite positive. It's why we're doing this series effectively. And we started off with, how do you construct a bullbox? How do you construct a bare box? Those were the first two in the series. Then we looked at the income statement and, you know, just breaking that down, how do you actually go through it? How does that factor into our analysis? But as you've correctly said, Ghost, the balance sheet is a really important part of that overall analysis. And again, this just shining a little bit of a light in terms of some of the detailed work we do in magic markets premium, where we do both a top down, but very much also a bottoms up look at specific global companies with a new company every single week. So again, if you're not a subscriber to Magic markets premium, go and have a look at that. It's only 99 rand a month. We think that's fantastic value for getting deep insights on global companies every single week. With that being said, ghost, the balance sheet, I'm going to jump in here, because for me, it's a question from a macro perspective. You look at a company and you say, okay, great, we know you're making money. This is how you're making money on the income statement. But what is the overall health of the company look like? And I'm going to maybe just start off with a very high level point here, and then I'm going to hand over to you in terms of breaking some of that down. The first point I'm going to bring in here, Ghost, is when you're looking at a balance sheet, you first of all have to look at it and say, okay, great, what are the assets? What are the liabilities? That's effectively what you're picking up on the balance sheet. And that tells you a lot around the health of a company. The health of the balance sheet. How much stress or the stress are they in, or do they actually have significant Runway to actually lever up that balance sheet to generate the kind of growth? And one of the metrics we look at as well, alongside a look at the balance sheet, is we often look at the credit rating because ratings agencies are out there, certainly on the larger companies, and they say, you know, this company is investment grade or they're not investment grade. That often gives you decent insights to help validate your own analysis. And that tells you, as I indicated, about the health of the balance sheet. The second point that I want to just touch on from a high level is the shape of that balance sheet. And that's where we start looking at things like the cash flow statements. We look at, you know, what is the structure of the liabilities look like? We're going to unpack all of this for you. Those two things can tell you very different things around what some of the pressure points or advantageous points are when looking at a company and when analyzing the balance sheet specifically. Ghost.
[00:04:04] Speaker A: Yeah. It's all about what happens to those profits once they come through, right? They land in a balance sheet. And if the balance sheet is nice and healthy, there will be more profits for you as an investor if the balance sheet is problematic, then there will be less profits for you as an investor, either. The banks will need to get paid potentially all the money. I mean, that does happen. You often see it where companies at an EBIT level, which is earnings before interest and taxes, can only actually cover the interest and taxes they can pay the banks. And if there's any profits left over, which they usually aren't, really, there might be a little bit of tax, and that's it. There's not much left for shareholders. So if you ignore the balance sheet, you do so at your own peril. I mean, just think about your personal finances. You can have a great paying job, but if you've got way too much debt, you're supporting the family. That's a too big for your salary, or whatever the case may be. You very quickly get into a situation where you are chipping into your balance sheet, and you know, that's, that's difficult. And from a company perspective, that's not what you want to see, at least not over the long term. Bad years do happen, but the strength of the balance sheet will determine whether or not a company makes it through the bad year or doesn't. So you can't ignore it. But you also can't really ignore the income statement at the same time, because that's what is feeding the balance sheet. So that's why we did the income statement first last week. If you haven't listened to that show, go and check it out. We talked about some of the key line items on the income statement and what you need to look at. And the key lines there that then feed into the balance sheet are concepts like, you know, looking at EBITDA, because that is the money that is in the business before they go and cover stuff like depreciation, for example. Now, where is depreciation going to come from? It's going to come from the balance sheet. If you don't go and look at the balance sheet and understand the type of assets that are sitting there, you also won't understand the depreciation line, which is basically the way those assets depreciate or reduce in value over time as they are used up. You also won't be able to go and understand the capex then, because another important concept, and then I'll stop there and give mo a chance, is that capex is going to be one of two types of things. It's either going to be maintenance capex, which means you are simply investing in your assets to keep them going. So if something depreciates by $1,000 this year, or 1000 rand or 1000 whatever. If that's the capex that you spend on it to just maintain the thin, then that is maintenance capex. But if you need new machinery, or you need new equipment, or you need new whatever, then that is expansion capex. So if you see capex way in excess of depreciation, that means that the business is investing for growth. If you see capex that is relatively similar to depreciation, it means that it's really only maintaining what it has. So the point here is that ignoring the balance sheet is just not a good option. And looking at only the balance sheet and ignoring the income statement is also not a great option.
[00:06:44] Speaker B: Yeah, it's why linking these two is really so important. Because as we indicated, you can have decent income, but if you're over indebted, that's not going to translate into returns for your shareholders. And in fact, we see this. I mean, you bring up the debt point. So I'll maybe start off with a debt point, because when looking at the balance sheet, you look at the liability side. This effectively tells you what the company owes. Now, remember, you can break those up, you can break it up into the long term liabilities. You know, a company goes and raises debt in the long end. This helps them fund their operations, helps them fund their capex over the longer term, and they've got to pay back that debt over a long period of time. So think of this in your own finances, for example, as a mortgage on your home. You know, you effectively have that liability. It's on your balance sheet, but you don't have to pay all of that back today. What you have to pay back today are your immediate, you know, recurring payments. And so that does have a cash flow impact in the short term. It comes through in terms of the financing activities, but it doesn't necessarily mean that you're in the hole for the entire liability. So keep an eye out in terms of the differentiation between the short term and the longer term liabilities. Now, what makes up short term liabilities? Again, if you look at this, a company is going to have suppliers. They don't necessarily pay them all in one go. They don't pay them upfront. They might have terms in terms of how long they have to pay back some of those liabilities. And again, if you are a business, or even again, in your own personal finances, think of this as your credit card. You know, you can go out, you can spend the money, you don't have to really pay that immediately. Maybe you've got to pay it in a month's time. That makes up the short term liability side of the balance sheet. And when you wrap these up together, that gives you the total liabilities. Now you've got to look at that versus the company's assets. And the same logic applies here, because you've got the long term assets and the short term assets. And again, long term assets, you know, it's questionable. Companies have a lot of their capex goes into that. They tend to amortize that over a long period of time. Think of your house. This is a good example. It's a long term asset. You're not quite going to go and sell your house in order to settle some of your shorter term liabilities unless you really have to. So that goes into that part of the balance sheet, and it's not as though you're going to revalue that regularly. But more important for me, here are some of the shorter term assets, because this shows you how much cash a business has on hand. And again, remember, it's not just cash. You might have actually sold a whole lot of products to customers. They've got to pay you back, but maybe over the next couple of months. So not quite long term. It's more shorter term. And the mix between this really gives you a sense of what a company's overall working capital looks like. So pay attention to what this means from a shape of the balance sheet perspective. Obviously, you look at the overall levels that tells you about the health, but look at the shape, because the shape is really important in terms of informing what the short term cash flows are. And quite often when a company starts to hit the wall, you start to see that pop up. In terms of the shorter term cash flow crunches, you actually start to see an increase in working capital. Capital. That's what I'm looking out for when just looking at the assets and the liabilities on the balance sheet. I'm going to pause now, Ghost, and let you maybe come in here and just give us your views in terms of how we should look at the long term, short term split. Ghost.
[00:09:47] Speaker A: Yeah, absolutely. I think you've touched on a lot of the important stuff there. The working capital point is really, really important. You've got to go to the cash flow statement to see a lot of that. You can also just eyeball it and have a look at how inventory has changed year on year, how current assets have changed year on year. Like receivables, for example, have a look at the growth in revenue. If revenue is up 10%, but inventory is up 25%. We've got a problem. And the problem is that inventory is being sold too slowly. You've got a situation where a lot of money has now been tied up in inventory and you're not going to see that on the income statement at all. Where you're going to see that is on the balance sheet because the inventory line is going to get bigger. The only time you will see that problem coming through on the income statement is if the inventory has gotten so big that inventory obsolescence becomes an issue and they need to start writing that inventory down. Then you're going to see it come through in cost of sales. But by then, it's almost too late. The pain has been taken. So the balance sheet helps you figure out what might be going on in the business that management is not really telling you right now. They're not going to go and volunteer information very easily like, hey, we've actually got a huge problem in our inventory in the US. When you can work with an earnings transcript that is available to everyone, analysts will ask these kind of questions and it can really help you with your analysis. In South Africa, on the local market, it's not so easy. Unfortunately. Unless you can get your hands on a recording of the analyst presentation or whatever the case is, you're not necessarily going to get those kind of questions. You've got to go and do the work yourself. Go and think about the stuff yourself. Another really good example that's important is if your account's payable, so that's what you owe your suppliers. If that comes down. But your cost of sales, which is the inventory, for example, you bought from your suppliers, is sideways or higher, then it means your suppliers are giving you less favorable terms. They want you to pay them faster. That is another squeeze on working capital. And eventually a working capital problem becomes a bigger balance sheet problem. So what happens is, if the balance sheet is relatively low on long term debt, if working capital is starting to become an issue, then you start to see things like the company bringing on term debt or revolving credit facilities, and they'll use great words like, oh, we're just building headroom and all that kind of thing. The reality is if a business suddenly needs debt and it didn't need debt before, there better be some very good reasons for that. And if the reason is that working capital is under pressure, then just understand you are getting into serious danger zone territory and things can go wrong really, really quickly. It's the old joke, you know, how did you go bankrupt gradually and then suddenly, and that is exactly what happens. And you can spot it happening in things like working capital and then comparing that to the overall level of debt in the business and looking for those trends.
[00:12:30] Speaker B: Yeah, ghost, I mean, that's all fantastic. And I think the key differentiator between some of the points I'd raised and the points you've just raised now is that I was taking a static look at a point in time in terms of the overall health, maybe even just the shape of the company's balance sheet. But you've touched on a very important point, and that's looking at the trends in some of those metrics. I mean, you've mentioned receivables and payables. And this is where I want to actually just raise a couple of interesting points around ratios that you can consider. Because when you're looking at this, I mentioned the current liabilities versus the current assets. You know, what do you have on hand versus what you have to pay right now? And that comes through in what you would call the current ratio. So effectively, that's really just current assets over current liabilities. And what you're looking for here is a ratio above one, because this means that you have more than enough cash on hand, short term assets on hand, in order to settle those short term liabilities. If you have a ratio below one, you're starting to run into danger territory. So that's an interesting ratio to look at. The other one to look at is when you're looking at the overall health of the balance sheet, it's debt to equity or debt to capital, because this tells you how important debt is on the company's balance sheet and effectively translates directly into what is the equity, the shareholders equity on the balance sheet. In some firms, you actually have a lot more debt than you actually have assets. And in these instances, you actually have negative shareholder equity. We've seen that. We've seen that, for example, in some of the hotel groups that we've covered, where you have negative net equity on the balance sheet. And this starts to mess with some of the other metrics that you might want to look at, like, for example, return on equity. So let's just assume a company has positive equity. Return on equity effectively is telling you what mix, what percentage of the overall returns gets attributed to equity holders. And this is quite important, certainly when there's a lot of debt on the balance sheet. Because remember, a company's total enterprise value is comprised of both returns to debt holders as well as equity holders. Now, I want to move from that ghost onto a related point. And this is talking to, for example, the cash flow statement, because we've spoken a lot about the balance sheet, but the cash flow statement is almost a hybrid because it looks a lot like the income statement. If you look at the income statement, you look at the cash flow statement, lots of similarities, and that's because you start off with effectively, how much money the business generates. But the reason I raise this now in the balance sheet discussion is on the cash flow statement, you actually get to break it down in terms of what is the company's operating cash flow. That's maybe the first level that you're going to be looking at. And this tells you how much cash is generated from the normal operations goes. The next level you look at after operating cash flow is really two levels. One is cash flow from financing activities. And this is really where the companies out there in the debt markets, they might go out there, they might raise some long term debt, and this is going to result in additional cash flow. So it's going to flatter the cash flow profile. It's going to look as though the company's generating that cash, but that's not coming from operating activities, it's coming from raising debt, and that flows directly onto the balance sheet. So it might make the cash flow look better, but it actually makes the balance sheet look a little bit worse. And then the next item that you're looking at on the cash flow statement is cash flow from investing activities as well, because this is where the company's investment in capex, you know, effectively, you know, they might need equipment, they might need to buy properties and so forth. That's what you're going to see in terms of cash flow from investing activities. And in some instances, if they're investing, that's going to be a drain on cash flow. But remember, that might eventually give you an uptick in terms of your earnings on the income statement. What you're also looking out for here in terms of investing is if a company had investments in subsidiaries that they've sold out, for example, that's going to come through. If they sell that, that's going to come through in terms of the cash flow, it's going to make the cash flow look fantastic. But again, the balance sheet impact is that you're actually going to see a decrease on the asset side. And the reason I raised this is you've got to actually link all of these things together. For me, the cash flow statement is a nice way to link what's happening operationally and on the income statement. What's happening there, linking all of that back through to what's actually happening on the company's balance sheet and its overall health.
[00:16:27] Speaker A: So I know a lot of this can be quite overwhelming. And I think, you know, just to start to bring this podcast to a close, and looking back on the one we did last week on the income statement as well, you know, it's difficult to go and listen to this and think, wow, that sounds, that sounds tough, and how am I going to do this? And it's hard to follow. It isn't easy. Obviously. If it was straightforward, then accountants wouldn't have a job and neither would investment analysts, and everyone would make money in the markets. But if you want to elevate yourself from just reading on online websites about what other people think about a company and then actually doing the work yourself, then you need to start engaging with the financials. And as much as they can be quite complicated animals, and they are certainly extremely complicated once you start getting into the notes to the financials, if you go back and listen to last week's show on income statements and you listen to this one again and just take a highlighter out or however you want to do it and just go and actually note the bits that are really important and just read as much as you can. Go and look across different industries, different companies. You don't have to try and understand everything day one, and you don't need to get too bogged down in the really difficult accounting rules and major changes to ifrs and everything else. Don't worry too much about that. Just start somewhere and look for the trends. And especially look for reasons why management's narrative is not necessarily tying up with what you are seeing in the financials, because that is where the money is ready to be made in the markets. The stocks will initially move on management's narrative because people are quick, algorithms are quick, traders are looking for keywords, etcetera. That's the initial movement on a stock. But if you want to get the long term investing right, then looking at how these trends are moving over time, looking at management's commentary and looking for the gaps or the things that management's maybe not telling you that do look quite exciting because they sometimes do that as well. Management teams sometimes play their cards very close to their chests in general, and then you've got to go and do the hard work to kind of figure it all out. It really will take your ability to understand equities firmly to the next level, and it's a very useful use of your time I think especially if it's something you are passionate about, is learning about how companies make money, learning about why share prices move. You're going to have to dig into the financials a little bit, and I think we certainly hope that the past two shows have really helped you with that.
[00:18:35] Speaker B: Yeah, ghost, it's really about taking some of that fear away from people who are interested in the space. I think your point around what management's telling you versus what the numbers are telling you, that's really where financial analysis comes into its own. I mean, we so many times, so often you go through the financials, you just look at, simplistically, some of the ratios that we have highlighted on the show today, and you can actually find that one ratio that's heading in the wrong direction or in the opposite direction to the narrative that management's trying to sell out there. And the unfortunate thing around just overall financial journalism today is that it tends to be sound bitey. It looks at the headlines, it looks at what, you know, effectively management is trying to tell you on the earnings call. It's not going into the weeds. It's not looking at the numbers necessarily and finding those nuggets that are maybe counter narrative that actually tell you what you need to know about a company. And that's what you want to find when you're investing, when you're parting with your hard earned money, when you're putting it into a stock, into a company over the longer term, you want to actually go and have a look at that balance sheet and know that you are investing in a company that's healthy and that that actually can correlate and tie up to the company sustainably generating economic returns. That's unfortunately where we're going to leave it this week. We hope you've enjoyed this show. We hope you've enjoyed the series just in terms of how to, how to look at a bull box, how to look at a bare box, how to look at an income statement, and now how to look at cash flows and the balance sheet. If you've missed those prior shows, go and check them out. They are on the website. And if you are interested in this level of detail on specific global companies, go and check out magic markets premium for only 99 reals a month. We hope you've enjoyed the show. Hit us up on social media. It's a marketspod, one word at Finance. Ghost and Uhammad Nalla, all on XDev. Or go and find us on LinkedIn. Pop us a note on there. We hope you've enjoyed it until next week. Same time, same place. Thanks and cheers. Ciao.
[00:20:24] Speaker A: This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
