Why the balance sheet may not balance

There are many reasons why things may not be exactly as they appear…

a woman

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Many investors prefer to invest in a company that owns a lot of physical assets because these can always be sold to raise cash if it ever gets into difficulties. It presents a natural 'floor' to a company's valuation, lowering the investment risk.

The problem is that if the company gets into trouble, it often discovers that many of its assets are worth much less than the figure stated in its most recent balance sheet. Naturally, its liabilities will be extremely solid.

This isn't just because buyers take advantage of distressed sellers by offering low prices. Several other factors also conspire to drive down the shareholders' piece of the corporate pie.

Fails to reflect market realities

Back in 1985, the original textiles business of Berkshire Hathaway (NYSE: BRK.A, BRK.B) was wound up. When it auctioned off equipment that was valued in the accounts at $866,000 after depreciation, it received just $163,122. As Berkshire's boss Warren Buffett said in the next annual report: "Allowing for necessary pre- and post-sale costs, our net was less than zero."

The problem was that the value assigned to its machinery didn't reflect the state of the American textile market, which had collapsed under intense foreign competition. The most extreme example was some looms that had cost $5,000 apiece less than five years earlier and didn't sell at auction. They eventually went for $26 each to a buyer who wanted them for scrap!

Balance sheets don't always reflect market values.

Employees' claims

A contingent liability is a liability that could arise in the future – it is 'contingent' on some event or set of circumstances coming to pass. Companies allow for these by estimating what they might have to pay, the probability of having to pay and the dates when this might happen. Then they use discounted cashflow techniques to produce the figure that appears in the accounts.

Leaving aside the tendency of some companies to undervalue their contingent liabilities, some simply won't be mentioned in the accounts. One example is the redundancy payments that might be paid to its workforce. A business that's doing well doesn't have to worry about this, but if it gets into difficulties it could be forced to lay off a lot of staff whose redundancy payments would eat away at the assets.

This is much less of an issue in America where it's relatively easy to get rid of staff without too much comeback. But it's something to be wary of in Australia, where it can be expensive to dismiss staff.

Too many sellers

If a particular sector of the stock market is in trouble, many similar assets will come onto the market at the same time, which, in turn, depresses their value. This often happens in the housing market when several houses in the same street are up for sale and there's a lack of buying interest. When the desperate sellers drop their prices, the others have to respond similarly or their chances of selling will drop dramatically.

Any time a seller wants to turn an illiquid asset like property into cash within a short timeframe, they will usually only receive a fraction of its market value — if they can find a buyer — because buyers take advantage of distressed sellers and will probably be a little suspicious.

There's an excellent illustration of this in the dystopian thriller In Time, which is set in a world where money buys you more life and when you run out then you drop dead on the spot. In one scene, the heroes have a minute to live and the only thing that can save them is if a pawnbroker gives them something for an extremely valuable pair of diamond earrings.

Unfortunately, the pawnbroker already knows how desperate they are because the leading lady hasn't covered the clock on her arm that shows how much time she has left. So he makes a ridiculously low offer. When she complains, he tells her "you can take the 48 hours, or you can be a pretty corpse". When you have only one offer, you're often forced to accept it.

Goodwill or badwill?

Many investors are suspicious of goodwill and other intangible assets, such as brands and trademarks, as they can vanish in the proverbial puff of smoke when a company gets into trouble. Often the reason for the company's difficulties is that the intangible assets haven't been pulling their weight, and sales have consequently dropped off at an alarming rate.

When this happens, it's extremely likely that the previous amortisation charges — the writing off of goodwill over time — haven't reflected this deterioration – and hence those assets will be significantly overvalued.

A good example is the fate of Netscape Communications. In 1996 it was one of the strongest internet companies, with a brand worth billions and investors scrambled to buy its shares — yet a few years later it was all but worthless. Netscape had been hammered by the ferocious competition from Microsoft Corporation (Nasdaq: MSFT), and it also severely damaged its brand when a much-touted upgrade to its flagship product made it much worse, so its goodwill simply melted away.

While a company should reduce the value of its goodwill if it is "permanently impaired", as happened to Netscape, often this happens long after the event, and investors who were relying on the balance sheet will get a nasty shock.

Photon Group Limited (ASX: PGA) and Neptune Marine Services Ltd (ASX: NMS) are two Australian companies that had loads of goodwill/intangibles on their balance sheets thanks to too many overpriced acquisitions. Both businesses have had to write down the value of that goodwill and raise more equity, and both are now trading at fractions of their share prices of a few years ago.

One of the more stable asset classes is residential property. House prices in Australia tend not to fall too heavily so financial institutions will generally lend far larger amounts to individuals to buy property than any other type of asset. Of course, if the company has too much debt stacked up against those properties such as Centro Property Group was during the GFC, the debts will melt asset values like ice cream on a hot sunny day.

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Take Stock is The Motley Fool Australia's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691).

A version of this article, written by Tony Luckett, originally appeared on fool.co.uk. It has been updated by Mike King.

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