Generally, increasing assets are a sign that the company is growing, but everyone can relate to the fact that there is much more behind the scenes than just looking at the assets. The goal is to determine how the asset growth of a company is financed.
To do so all we need is the last few years of a company’s balance sheet and the most basic financial statement equation:
The assets of a company are what the company owns. Typical examples of assets are; equipment to make a product, buildings owned, raw materials to create a product, inventory of the product to sell and cash in the bank.
Think of your household. Your car, your home, your furniture, TVs, Computers, bank accounts etc.
Generally, increasing assets are a sign that the company is growing, but everyone can relate to the fact that there is much more behind the scenes than just looking at the assets. Back to our household example:
Imagine watching a neighbor pull a sparkling brand new BMW into their driveway, getting out dressed in his fancy Italian suit, talking on the latest smartphone, and coming over to ask if you can watch his house for 2 weeks while he travels to sail in the Caribbean. You may think he is making it big, right? Maybe he got a big bonus from work, or a promotion…
That may very well be the case, or he may be racking up debt (liabilities) to finance these assets.
You may never find out which option applies to your neighbor, but thankfully the SEC requires publicly traded companies to be a little more transparent with their financials than your neighbors.
With companies, you can easily determine whether those assets (like your neighbor’s BMW and house) are a result of a booming business which is able to generate the cash required to pay for those assets, or whether those assets have been financed by debt.
Look back at the balance sheet equation.
Assets = Liabilities + Equity
We want to evaluate the change in a company’s assets.
The Greek letter delta means ‘the change in’. So “the change in assets is equal to the change in liabilities plus equity is written as:
As assets increase or decrease, Liabilities and/or Shareholder Equity must increase or decrease in parallel. If assets increase by $1 billion, the sum of the changes in Liabilities and Equity must increase $1 billion as well.
Some causes for an increase in liabilities would be:
- Increase in accounts payable
- Increase in short term debt
- Increase in long term debt
Some causes for an increase in Shareholder Equity would be:
- Additional paid in capital (selling newly issued shares)
- Increase in retained earnings
Let’s look a few examples to see this in action.
First up, Tesla Motors most recent 10-Q report (Ticker: TSLA):
(For a detailed guide on how and where to get a company like Tesla’s balance sheet, see our Guide on the Balance Sheet Here. http://begintoinvest.com/evaluating-financial-statements-the-balance-sheet/ )
(click to enlarge)
All I have done is download the data into excel and organized it a little neater. The column to pay attention to is the far right column, which represents the change in values of Tesla’s balance sheet from last quarter compared to the most recent quarter. I have emphasized the 3 lines we need for our equation above in bold; Total Assets, Total Liabilities and Total Equity.
What does this tell us? First off, we see Tesla had a huge increase in cash and cash equivalents (about $1.5 billion) and therefore a large increase in total assets as well, $2.08 billion in total. This must be a good thing right? What company would not want to have more cash in the bank and assets in general?
Take a look further down into the liabilities part of the balance sheet and notice that total liabilities has increased more than $1.7 billion! Most of which has come from long term debt.
Total shareholder equity has increased just $244 million.
So, of Tesla’s $2.08 billion in assets acquired in the first quarter of 2014, $1.76 billion was financed by debt compared to just $244 million from Shareholder Equity.
What does this tell potential investors in Tesla? The company is not generating sufficent cash from its business to grow as it wants to, so it is forced to take out loans to pay for its growth.
Specifically for Tesla, the large increase in liabilities was due to a recent bond offering, reported on the balance sheet as long term debt (Read the Bloomberg news story here: http://www.bloomberg.com/news/2014-02-28/tesla-raises-2-billion-with-convertible-debt-to-finance-factory.html)
Right now, the proceeds from that bond offering are still sitting as cash in the company’s bank account. They are expected to go into property, plant and equipment for the company’s battery “gigafactories” by the end of the year.
Let’s compare Tesla’s balance sheet to a company like Hanes Brands (Ticker: HBI).
Below is the data from Hanes Brands last couple 10-K reports:
And the info in a pie chart:
Here we see a much different picture. Hanes is financing its growth primarily by normal business operations, a sign of a financially successful company.
We can see that the primary source of increase in shareholder’s equity is an increase in retained earnings. In other words, the new assets of Hanes Brands are purchased from the company’s previous profits.
This type of growth tells investors a couple of things:
First – That Hanes Brands will be able to continue to grow.
Because its core business is so strong, it does not require outside capital. Hanes will be able to continue growing regardless of availability of money from banks or investors, like those Tesla is dependent on.
Second – and most important for investors – Hanes Brands growth is less risky for investors.
Hanes Brands is using its savings to finance new assets that hopefully lead to additional sales in the future. But if that vision doesn’t pan out the way Hanes Brands foresaw it will still be able to live to see another day, unlike Tesla which may not be able to pay off the debt if it leads to no future profits.
Consider 2 people starting a new business.
Business man 1 saves up $250,000 to start a business. The business fails horribly. What happens to this business man? His savings is gone, but hes not on the hook to pay anyone. He keeps his house and assets.
Business man 2 immediately borrows $250,000 from a bank to start his business, which suffers the same fate as the first man’s. But now Business man 2 must still pay back the loan, even though he is not getting any sales through his business. Now he is in a much more precarious position, and may have to declare bankruptcy.
A company that is able to finance its own growth is a much stronger, more successful company with a much higher chance for a long term positive return for investors. In fact, this touches on one of our criteria in a recent post ” 9 Signs of a Competitive Advantage” – Check it out!
Using this type of analysis, you will be able to determine where a company is getting its money to purchase additional assets.
Remember your neighbor with the new BMW? If he is more like the company Tesla, that car and Caribbean vacation were financed with credit cards and car loans. If he is more like Hanes Brands, he bought the new beamer with his savings. Who would you rather be?
It should be noted, an increase in debt is not a sole reason not to invest in a company. If I were a speculative investor in Tesla, the data above tells me to research the details of the debt and evaluate how Tesla can pay it off.
In fact, this data is somewhat cherry picked for the Tesla situation. A better analysis would include the company’s asset, liabilities and shareholder equity balances over much longer periods of time. Over the last 5 years, how has Tesla’s assets, liabilities and shareholder equity changed? That will give you a better idea of Tesla’s financial shape.
Debt alone is not a predictor of failure, but it does mean additional risk for investors. If a company is not able to run without borrowing, it should throw up a red flag for investors. If a company is unable to grow without borrowing, investors need to take note that if the company’s idea for growth doesn’t pan out, its debt is coming due and it must find a way to pay it off, or else your investment is gone.