The income of most businesses directly relates to the net assets and working capital on its balance sheet. For the sake of clarity, here’s the most basic definition of a balance sheet that I could find:
“The balance sheet derives its name from the fact that it must balance, as the total assets always equals the liabilities plus shareholders equity, which represents the owners’ stake in the business.
How to get started
I like to begin by building a modified balance sheet. I make common sense adjustments to asset values and move items around like restricted cash and tax losses that may be carried as liabilities for accounting purposes. The template I use was posted by Michael Rapps on Greebackd.
Working Capital = Current Assets — Current Liabilities
The difference between current assets and current liabilities, working capital is the amount of money a business has on hand to pay its debts.
Many investors have made a career out of deep value investing — buying money losing companies that don’t pay a dividend, but they trade at a discount to their working capital and their losses are containable for the next few years while management works to fix the situation.
Three Key Questions to Ask:
1. Is Shareholder equity growing, stable or shrinking over time?
If the company is burning cash every quarter, then it doesn’t matter if it is debt free with a great current ratio and huge working capital buffer. You’re holding a melting icecube. At some point the money will run out.
2. Is the liquidation value significantly higher than the market value?
Always assume a liquidation scenario will take place under duress conditions.
3. What is the catalyst to unlocking the liquidation value?
