No. of Recommendations: 5

The advice to invest in companies with strong balance sheets can be a bit misleading. A company can have a strong balance sheet and be on the downward cycle within its industry or as a business. Kodak had a bullet proof balance sheet for a decade and no clue how to move past its photo film business model. Another company could be expanding nicely and instead of rolling that cash generated into cash and equivalents or short term investments they use that cash to continue their expansion.

Which company do you really want to invest in the bomb proof balance sheet of a going no where company or company that has a "good enough" balance sheet that is growing strongly?

What constitutes a "strong balance sheet" may not be the best question to ask. What we really want is a financially durable company. To discover if a company is financially durable we often have to study all three financial statements and their interconnections.

Like the fast growing company I mentioned above that is building out using the cash it generates. If the economy takes a hit and building out become less important than saving for this impending rainy day stretch they simply slow down the build out and build up the balance sheet. The balance sheet may or may not tell us enough of the story for us to know if they are solid or not. It would be a shame to sell them because their balance sheet looks weaker than others when the full story is that they are plenty sound.

When cutting down a tree with a saw or chopping it with an axe we always leave 'holding wood' a pivot point or hinge of wood that helps control the fall. Ask a sawyer how much holding wood to leave and they will tell you 'enough'. It is the same when it comes to investing the balance sheet needs to be good enough for you and for the company. When presented with the choice of two companies you may very well choose slightly less growth and a solid balance sheet over the company that is growing faster but has a smaller fall back position, there is nothing wrong with that choice.

What is good enough? It varies by investor and by industry.

General indicators are:
Fixed Cost Coverage Ratio or Interest coverage ratio over 4
Current ratio over 2
Quick Ratio over 1
Growing C&E and investments
Liabilities growing in proportion to the rest of the balance sheet.

All of the above can float around as you move from industry to industry.

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