Every time we meet new friends, the first impression is established through our eyes – how’s the guy figure, how fancy he wears, etc. You definitely cannot tell what he/she was several years ago, but – let’s say someone introduces what the guy was 5-year-ago – you could probably get the idea what happened to him/her. You know, like whether the guy gets richer or not.
Nothing different in how we get to know a company. The balance sheet to a company is exactly the snapshot to a person – the balance sheet shows what the company looks like by what it “owns” and “owes” at a certain point in time. You never know what the company was 5 years ago by the current one. However, if you happened to have their 5-year-ago balance sheet, you kind of understand what they’ve gone through.
In this blog, we will introduce the “Yvonne’s Yacht” for you to master the balance sheet analysis. The Yacht visualizes the numbers – which don’t lie – and turns into vivid figures to memorize and analyze better.
What is Yvonne’s Yacht?
The accounts on the “yacht” and how it is positioned are matched to the balance sheet structure. With assets on the left side, the liabilities and equity are on the right side. The width of the boxes represents the size of the account in monetary value terms.
On the left side, the position of the asset is arranged in the order of turnover days, i.e. the days needed for an asset to turn into cash $$. Here we call it the “cash conversion continuum”. For example, the inventory days are 380 meaning it takes them 380 days to turn the inventory into cash.
On the right side, the position of liabilities and equity is also based on the turnover days – the days the company is required to repay its liabilities and equity. We call it the “repayment continuum”.
However, the yacht above is just a perfect example – the cash conversion cycle of the assets is matched perfectly to the repayment of the capital. In reality, the cyclical risk of a business and disruptions in the general economy will always result in an imperfect yacht.
4 Typical Shapes of Yvonne’s Yachts
There are generally 4 typical shapes. 2 questions are always asked to characterize them:
(1) About stability: Can the company survive during a bad time? [ Review at Equity Buffer is your answer is strongly recommended as it prepares the answer. ]
(2) About efficiency: How good can the company generate cash (which is future equity)?
1st Shape
Assets in the left match perfectly to the capital in the right, and the non-current assets & non-current liabilities and equity are dominating rather than the current portion. Heavy-asset companies like real estate, usually own such shape.
- Stability: Slightly stable. Companies have a small amount of cash, thus less likely to tide over liquidity challenges which require huge piles of $$$. Meanwhile, companies have strong equity buffer and relatively small current debt which requires immediate repayment – so less likely for liquidity challenges to happen.
- Efficiency: Efficient. Assets consist of more working capital with even more PP&E (Property, Plant, and Equipment) which are all generating revenues.
2nd Shape
Just like 1st shape, assets are matching capital. However, the current portion dominates the non-current. Light asset companies including trading companies, Internet companies (e.g. e-commerce), etc. tend to have such shape.
- Stability: Slightly unstable. Even though the company has a large cash position, the maturing debt that requires immediate repayment is huge.
- Efficiency: Inefficient. The company simply has a big chunk of sitting cash. Fewer assets are put into generating profits.
3rd Shape
Structural mismatch happens: more current assets vs. more non-current capital means long-term capital is financing short-term assets. Companies operating in a very-inefficient way or in a transition period temporarily usually have such shape.
- Stability: Most stable. Companies have a strong cash position while minimal ST debt demands immediate payback!
- Efficiency: Most Inefficient. As we all know, LT (long term) capital is more expensive than ST (short term) and designed to finance LT assets. How can you be efficient when you crack a nut using a sledgehammer?! It is also quite BAD especially for debt holders (usually banks), as the company misuses the LT debt thus generating less revenue for repayment than expected.
4th Shape
Structural mismatch happens but in a different way: more non-current assets vs more current liabilities. Companies holding a “bridge loan” temporarily usually own such shape.
- Stability: Most unstable. Quite clear – imagine the bank calls the payback of loan, the company just don’t have cash for them.
- Efficiency: Most efficient. From the company owner’s perspective, they use cheaper ST loans to finance LT assets – is there anything better than that? It’s just destructive to the debt holders (banks) as the chances to have their money back are minimal!
Navigate Yvonne’s Yacht through the sea of time
Remember the balance sheet is just snapshots of a company at a certain point in time, while time never stays still. Every company will experience start-up, growing, mature, and decline phases just like the life of a human being. [For more discussion please refer to Daniel’s Dolphin and the Business Cycle].
Therefore Yvonne’s Yacht structure will surely be changing all the time, from #3 or #4 to #1 or #2 for example. As explained above, #3 & #4 shape are comparably temporal stage than #1 & #2!
To navigate the yacht, we should analyze its structure at different times and grasp what happens in the real world. The example shown below is a real-life case that experienced restructuring debt during FY2007 to FY2015.
Accounts are complicated and indicate an imperfect yacht shape. Highlighted in red, LT debt was restructured into ST debt thus it moves up in the repayment continuum. The yacht is turning from likely a “#3 shape” to likely a “#2 shape”, i.e. a more efficient way.
You got the idea, right? The world is much more complex and always changing. But once we learn to navigate Yvonne’s Yacht through the sea of time, we are well equipped to see through the truth of a company!
Getting more curious about what happens during the change of the yacht? In case you miss it – the Golden rule of credit analysis: Cash Flow First! and its analysis tool Keep P.A.C.E.D. and Know Your Cashflow will give you the answer: cashflow.