Balance Sheet Analysis: Cash

If you remember, right when this blog got started, we did a post on balance sheet analysis and told readers that we would do a whole Distressed Debt Investing series on it. I intend to focus this series on non financial companies as the balance sheet of financial companies requires a completely seperate analysis (burn-downs)...so think of your typical industrial, retailer, transport, gaming company for our financial statement analysis discuss.

The first line item we are going to discuss on the balance sheet is cash. You may be asking yourself: "Hunter - Cash seems pretty simple...let's move on to deferred taxes and pensions." While I agree to some extent, the nuances revolving around cash analysis can be fairly intricate and tricky. I hope to point out some of the more salient points to consider when you are looking at plain old vanilla "cash."

Cash is 9 times out of 10 listed as the first asset on the balance sheet. It may or may not be combined with short term investments. In a company's 10K, usually in the first note of the financial statement, a company will list what the company believes cash equivalents are...for example, from a very well known hard-line retailer: "The Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. The Company's Cash Equivalents are carried at fair market value and consist primarily of high-grade commercial paper, money market funds and U.S. government agency securities."

Now, this is all well and good until you get a situation that occured in 2007 and 2008 with Auction Rate Securities and money market funds that broke the buck. For example, from Pinnacle Airlines' (PNCL) most recent 10K:

"We continue to own approximately $133.7 million par amount of auction rate securities (“ARS”). Due to unprecedented events in the credit markets during 2008, these investments became illiquid and have suffered a decline in fair value. We reported these investments as noncurrent assets on our consolidated balance sheet at December 31, 2008 at their estimated fair value of $116.9 million. We continue to earn interest on all of our ARS, and the majority of our ARS are still rated AAA/Aaa by the credit rating agencies. Most of the banks that structured and sold ARS to investors have entered into settlement agreements with various state and federal regulatory authorities that provide for the repurchase of ARS at par value from retail

investors and small businesses over the next 24 months. In addition, some banks have made offers to larger institutional investors to repurchase ARS at par value in 2009 and 2010 to the extent that institutional investors have been unable to sell their ARS. We have not yet received such an offer from the financial institution that structured and sold to us our ARS, and we have no assurance that we will receive such an offer. However, we anticipate that to the extent most major banks make settlement offers to their institutional clients, we would be made a similar offer for settlement related to our ARS holdings.

The collapse of the ARS market has had a significantly negative impact on our liquidity and the strength of our balance sheet. To partially offset this effect, we arranged for a $90.0 million margin loan facility (the “Credit Facility”) to be used to support our aircraft purchases and other working capital requirements. Although the Credit Facility has a maturity date in January 2010, we anticipate that the Credit Facility will remain outstanding until we receive an offer to repurchase our ARS or otherwise monetize our ARS portfolio. While we have effectively obtained the use of $90.0 million of our ARS through this Credit Facility, we do not have access to the remaining $43.7 million par amount of our ARS to support our liquidity needs. We do not know when we will be able to monetize our ARS portfolio, and we may have no choice but to sell our ARS at current distressed prices or to hold our securities until maturity, which could be 17 years or longer."
From lots of liquidity, to virtually none. Do I think an investor could of spotted this before Pinnacle made its disclosure? Yes. In previous 10Ks (for example, the 2005 10K before anyone knew what an ARS was) the company fully disclosed that they had invested in auction rate securities. I am sorry too keep pounding the table, but you have to do your homework. You have to read the last 3 or 4 10Ks to really understand what has been going on in the business for the past 5 or 6 years. This will put you about 95% ahead of the competition.

So, at this point, you should have a fairly good understanding what the definition of cash is for XYZ business. Fairly self-explanatory.

From here where do we go? We need to figure out the minimum amount of cash needed to operate the business. Cash requirements can arise from regulatory issues to the way working capital flows through the business, to covenant issues, etc. For example, many gaming companies need to maintain adequate cash to cover as some percentage/multiple the total amount of chips on the floor. Some credit agreements require a company to maintain a certain amount of cash less than be subject to more stringent covenants. Some companies (especially the very seasonal ones), need to build cash in certain periods of the year to buy inventory for the big seasonal sales. Cash, at its core, is liquidity. Liquidity is precious - especially in times like today - and more so in late 2008/early 2009.

Where do you find this information? Well, besides doing your doc work, you can call and ask the company, look at historical cash holdings and a quarter over quarter basis, calculate their cash conversion cycle versus sales. Why is this all important though?

When you know the amount of minimum cash a company must hold, you can calculate their excess cash holdings. Better yet, you can forecast their excess cash holdings in the future (conservative assumptions only). With that information, i.e. their expected free cash flow, you can build in assumptions for how much stock a company is able to buy back, how much debt they can pay off, what kind of expansion capex they can complete, what acquisitions are feasible, etc. A company's intrinsic value is the difference of cash in versus cash out for a business discounted back at a cost of capital. How would you ever figure this out if you didn't know the minimum amount of cash needed to run the business?

As an example, think of a widget company that needs to maintain 10M of cash on its balance sheet for working capital swings. If you project the company to generate, in aggregate, 1M of free cash per annum, you know that the company has 1M of excess capital to make moves with. From here, try to get a sense for the incremental return on capital a company has and you are one step closer to getting an adequate picture of what the future looks like for our widget company.

So after you know what the definition of cash is, how much cash the company is required to hold on the balance sheet, you need to know where this cash is. Seriously. Where is the cash located? Is the cash located in an overseas domicile where incremental returns on capital are significantly less than the United States? If so, the compay wants to repatriate that cash. But then they may get taxed on that repatriation. So now you have to discount your cash number. Confused yet?

Many times, at the near end of a company's 10K, there will be a listing of seperate financial statements either broken out by domicile or in the case of many levered borrowers by guarantors / non guarantors. Foreign subs are more likely than not guarantors of various debt agreements, and this can be a first clue to figuring out where the cash is located it. If a company is generating a substantial amount of its cash flow overseas, but has limited investment opportunities abroad, and no NOLs to shield the tax gains, you may have to adjust your carrying cash down. If you cannot find the information you are looking for, call the company. Asking the company for factual information is fine - asking them what their prospects are is a different matter: you decide that yourself, not based on a CEO talking his book.

Finally, and I will harp on this in the future, one of the most important questions you have to ask yourself as an analyst is: What is the company going to do with its cash? You know what cash means, you know where it is located, you know how much is required to run the business...but the $64,000 question is: What are the stewards of the capital going to do with it?

A management team compensated on sales is more than likely going to expand via discretionary capex. A management team compensated on EPS may be more likely to buy back stock. A management team earning 3% on incremental capital, when they have 8% bonds outstanding may buy back debt. Of course, I am assuming a management team does what is logically right based on incentives given...this is sometimes (actually, come to think of it, usually) not the case. It is sometimes comical to lay out what a management team has done with their excess capital (cash) ... I just looked at a lodging company that spent $1.5B of shareholder capital in 2006 and 2007 buying back stock at 22x forward EBITDA. How do you think that return on capital played out? Seriously.

And this is why gentle reader, it is imperative you know your management team. You HAVE to look at their track record of allocating shareholder (and lender) capital. You have to look at their past track records of companies they were at previously. You want to know how XYZ CEO is compensated as that will give you a first guess of where his interests lie. You need to get a sense for what opportunties are out there (from an IRR perspective) and how that will shape management decision making.

Yes, this is hard hard work. And we are only the balance sheet analysis of cash. But, remember what Alice Schroeder said about Buffett: "...he works like a demon from morning until night and he’s been doing that for 70 years." Security Analysis is hard, hard work. But, if you really have a passion for it, and get better a little bit every day, you can excel with the best of them.


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Lawrence D. Loeb 7/15/2009  

Good post Hunter.

It is also important to look at how the revolver loan (if any) relates to cash balances. Companies sometimes use the revolver as a piggy bank and try to maintain near zero cash balances, although that strategy is much more difficult in the current capital environment.

Analysts also need to look at the Current Liabilities section for any specific liabilities that the cash may be supporting, such as Prepaid Revenues. Some companies are lucky enough to collect revenues in advance of services that they provide. That cash, however, is not free to spend. A portion of it will have to be spent to support the services that were paid for.

Another item to watch for is cash held in reserve as part of a bank agreement.

Your discussion of overseas cash is very interesting, and important. Several years ago, the US Government allowed a short time frame for companies to repatriate funds tax free - so it is a real issue.

Foreign governments aren't happy to see those funds leave. They'd prefer to have those funds invested locally, and create difficulties with currency controls.

Cash is a simple subject, with a lot of VERY important subtle aspects.

Very good start.

Kevin Rogers 7/15/2009  

Nice job. Also keep in mind that some cash might be restricted cash and not available for day to day usage. Some times companies will label "restricted cash" on the balance and sometimes not. In the latter case, its likely to be somewhere in the footnotes. To re-interate what Hunter just said.. "dig dig dig" into those footnotes.

Anonymous,  7/16/2009  
This comment has been removed by a blog administrator.
Unknown 7/16/2009  

Great post. As you indicated, the challenges are formidable. How do you start your screening process. any favorite sites? criteria?

Next how do you determine what the incremental return on capital is?

Finally(for now) what about determining management's incentives are? Finding compensation figures seems pretty easy but I'm unsure as to how to determine if it's on a EPS, sales or return on invested capital.

Thank you for a great site

Anonymous,  7/23/2009  

Terrific post. I wonder, though, how you respond to the argument, noted by Klarman among others, that you learn 80% of what you need to know in the first 20% of the time you spend learning about an opportunity? I ask because there is practically an infinite amount to be learned about any security, a limited amount of time in each day, and a world of securities to review. One must be diligent, but when does one know that one has been diligent enough? I'm not dissing the hard work -- I'm just wondering how you apportion it.

Anonymous,  7/27/2009  

Interesting analysis on cash, but one question. From a corp fin perspective if the lodging company had no internal opportunities and since deleveraging would reduce equity returns, they either pay the money back as a dividend or repurchase stock. Tenders are stronger signals than open market repurchases but both accomplish the same thing. Sharholders get a return of captial, and are selling at quite a nice valuation at 22x EBITDA. While theoretically you are indifferent to a dividend or repurchase, what was large equity cusion on debt could become much smaller when markets decline so precipitously, so I prefer special dividends. Nevertheless, a company is right to return cash to its sharholders, I don't like when companies hoard cash and empire build or sit on shareholders' money trying to time the market with share repurchases.

Anonymous,  3/19/2012  

Hi Hunter,

Did you ever write a part 3, continuing where BS Analysis:Cash left off?




hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.