What is a 'strong balance sheet'?

As a stock investor, you may have frequently heard the term 'strong balance sheet'. Investing in companies having a strong balance sheet may be a wise decision, but nonetheless, it is a vague proposition. So what exactly is a 'strong balance sheet'

This article aims to explore the subject of what it is that makes a balance sheet strong, and how does an investor differentiate from a company with a strong balance sheet, from the one with a weak set of accounts. We will use Suzlon Energy (FY08 balance sheet) as a case study and explore its balance sheet to illustrate each concept.

1. Debt to Equity Ratio

   The importance of this metric for an investor cannot be over-emphasised. It can be measured by first adding the share capital and the reserves & surplus of the company to arrive at the Equity (also called book value or BV). These are the funds that belong to the company's owners. In Suzlon's case this amount was Rs 81,231 m at the end of FY08.

   Next is the amount of debt that the company has taken. That can be found by adding the unsecured and secured loans on the company's books. That amounts to Rs 99, 346 m. It would also help to differentiate the long term debt from that repayable in the short term (one year).

   Dividing the total debt by the equity we get a figure of 1.2. Debt/Equity of 1.2 means that for every rupee that the owners have put into the company; Rs 1.2 of debt has been taken. This is a significant amount of debt for a company to take and well above prudent levels. Thus Suzlon would score very low on this important metric to gauge whether it has a strong balance sheet.

   Companies take on such debt for various reasons. Two of the major one's being -

   1. For aggressive inorganic growth for which internally the company does not have enough cash flow / internal accruals.

   2. Use leverage to enhance performance indicators. A company that scores low on profitability and return ratios like ROE (return on equity) may use debt to artificially boost performance.

2. Current ratio

   Current ratio is a measure of short term liquidity of the company and indicates whether it will be able to meet its short term liabilities as and when they keep coming due throughout the year. It is calculated by dividing the current assets with the current liabilities of the company. In Suzlon's case these numbers were Rs 175,606 m and Rs 73,055 m respectively which can be divided to get a current ratio of 2.4. Thus Suzlon seemed to be comfortably placed in terms of short term liquidity at the end of FY08.

3. Working capital to sales

   Working capital of a company is calculated by subtracting the current liabilities from the current assets of the company. It is the amount of funds the company needs to facilitate daily operations to generate sales. For Suzlon the working capital was Rs 102,551 m. Suzlon's working capital to sales ratio for FY08 turns out to be 0.75, which means that for every rupee of sales that the company made, it needed to pump in Rs 0.75 to facilitate the operation of making that sale. The inference that can be drawn is that this company is very working capital intensive and needs large amounts of funds to create short term assets to make its sales. Thus each time its sales increase, it would need to keep pumping in more money to sustain the increment in sales.

4. Forex component

   Debt raised in foreign markets makes the company susceptible to changes in the conversion rates between the countries' currencies. Suzlon had raised Rs 20 bn in foreign currency convertible bonds (FCCB) in 2007 and the same are due in 2012. If the company's share price continues to remain below the strike price for the conversion of the FCCBs (strike price - Rs 359 for first tranche and Rs 371 for the second), it is highly likely that the company will have to pay back in 2012. If the Indian rupee weakens further by then, the company will have to pay significantly more then what it had raised, exposing it to foreign currency fluctuation losses.

Thus the above analysis of Suzlon's balance sheet shows that overall the company is not very well placed and has many weaknesses in its balance sheet that can lead to its downfall. This is because it has exposed itself to several risks that changes in the external environment can bring about from time to time. The risks can infact get magnified due to the weakness in the balance sheet. Investors would do well to guard themselves against such risky balance sheets and attach a suitable risk premium while buying the shares of such companies.