Value Investing And Balance Sheet Window Dressing

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  • Balance Sheet Window Dressing by Sui Chuan

As value investors, we have been taught to place greater emphasis on the balance sheet rather than the income statement during the course of our analysis. The argument is that earnings are more easily manipulated and less reliable as a true representation of a company. Indeed, operational earnings are often distorted by fair value gains, impairment charge or even which account is depreciation expenses charged under. However, there are reasons why the balance sheet is not perfect either, even if little has been said about it.

Like the income statement, albeit to a lesser extent, the balance sheet is susceptible to window dressing. Unsurprisingly, window dressing can skew the financial perception of a company. This is something I realized while analyzing Pico Far East Holdings Limited some time ago.

Balance Sheet Window Dressing

Looking at the annual balance sheet numbers, a balance-sheet-only indicator like debt-to-equity ratio seems to be highly favorable due to low amount of borrowings. However, a cross check of interest expenses with total debt to get an approximation of interest rate reveals that it is exceedingly high, hitting up 20.2% in 2011. This is an example of window dressing where the company pays its revolving debt facilities just before the close of its financial year so that its financial position looks more secure than it truly is. So how do we get a company’s true debt to equity ratio? One way which comes to my mind would be the through analyzing the intra-year financial statements.

Balance Sheet Window Dressing

Firstly, we can see that for the last 5 years, current borrowings in the middle of the year is about 2 to 10 times larger than end-of-year figures. It makes sense to me that the half-year figures are a true representation of the level of debt utilized by the company’s operations. Dividing finance expenses by the total level of debt, we get a much more reasonable average interest rate of 1.75% over the last 5 years.

Balance Sheet Window Dressing

By applying our new average interest rate to annual interest expenses, we can get an idea of the true level of debt required by the company. The resultant debt to equity is substantially higher than the original figures.

As a conclusion, I gather what I believe to be the few learning points from this exercise. First is of course, that balance sheet indicators can be misleading in spite of their reliance over income statement figures. The second point is that while we usually focus our attention on annual reports when analyzing historical figures, intra-year statements do have their utility from time to time. A thorough investor would benefit from analyzing both sources of information. Thirdly, the pitfalls of debt to equity is highlighted here due to the manipulability of short term debt. This can be sidestepped by using long term debt to equity ratio, but of course, as with all indicators, it does have its limitations as well. Finally, and something that has been reiterated many times, it is that we should never ever take things at face value.

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