The BS uncovered

State of Play: Having found five potential companies to invest in, I have started analysing the financials of one of them, Nomad Building Solutions. Last post looked at the income statement; this post looks at the balance sheet with guidance from “The Motley Fool Investment Guide” (‘MFIG’ / “the book”) by David and Tom Gardner (aka “the Fools”).

The pointers from the book are as follows:

1. Cash is “very, very, likable” and “we like to see lots of it.”

The Motley Fool boys like cash because it:
- indicates company is generating cash, which is a fairly important part of being a company (alternatively, they’ve done a share raising)
- gives an indication of the absolute floor price of the shares (although I tend to believe that cash is too easy to spend and just because a company had cash in the bank at 30 June doesn’t mean it was still there by close of business on 1 July)
- provides the ability to pay off debt
- provides the ability to acquire other businesses including competitors

They don’t actually define what “lots” is. At 30 June 2008, Nomad had $22m in cash, which was 19% of their net assets. This seems like lots to me. At 31 December 2008, they had $21m in cash, still 19% of net assets. So still lots although reducing.

Cash per share at 31 December 2008 was 15 cents, which, interestingly, was the low the share price reached on 27 January 2009. The $21m in cash was 1.6x the current borrowings, so if they couldn’t refinance they could just pay the bank back, which is a good position to be in.

I think we can conclude that the cash position is OK.


2. Avoid too much debt.

Again, no definition of “too much” provided. Lets look at whether they can pay their interest bill each year, as banks tend to get annoyed when businesses don’t pay their interest and start doing nasty things to them.

The interest cover ratio, aka, ICR (net profit before interest, tax, depreciation and amortisation or “EBITDA” divided by finance costs) for FY2008 was 16.0 times. That is, they can pay their interest or “finance costs” 16 times over from the cash they generated over the year. So, it seems to me that they do not have “too much” debt.

For the half year to 31 Dec 2008, the ICR had fallen to 6.1 (ignoring the impairment of goodwill), which still seems a quite healthy figure by itself, although the significant drop is a bad sign. I’ve ignored the impairment of goodwill because, like depreciation and amortisation, it is a non-cash item and does not affect their ability to fork out cash to the bank.

3. Make sure growth in accounts receivable and inventory approximates sales growth.

The Fools see accounts receivable and inventory as being more like liabilities than assets because they represent a (temporary) failure to generate cash. For the half-year to 31 December 2008, revenue had increased 62% compared to the same period in the year before, whereas, accounts receivable and inventories had gone down 14% over the six months. So Nomad are getting better at generating cash. On the surface seems good.

4. Do whatever ratios catch your fancy.

Examples provided in the book include:

Current Ratio: current assets divided by current liabilities. It is a test of short term liquidity, in other words, can they pay their bills and can they protect themselves from unforeseen circumstances? The Fools like this ratio to be above 2. For small caps, they like it higher still.

For Nomad, we get the following results:
FY2008 1.18
HY2009 1.05

Doesn’t quite pass muster, particularly as it is falling. Looking at the balance sheet, we see that current liabilities stayed virtually the same over the 6 months at $87.8m. Current assets however fell from $103.4m to $93.4m. So they have met criteria 3 above, but it has all gone towards meeting the cost blow-out, so perhaps was driven by necessity. If the cost issue continues, they could be in real trouble.

Quick Ratio: current assets minus inventory divided by current liabilities. It is a harsher test of liquidity because its looking only at cash and receivables to meet short term liabilities.

For Nomad, we get the following results:

FY2007 1.19
FY2008 0.88
HY2009 0.82

So, the movement over FY2008 was not good and the six months to Dec 2008 made things worse. This is basically saying that Nomad are dependent on selling inventory to be able to pay their bills. Note 1 of the financial statements says that inventory includes (i) Raw materials and stores, work in progress and finished goods and (ii) Construction work in progress less progress billings. It represents about 20% of the net assets. I don’t really understand why a building company has such a high inventory. It appears they are building buildings and then looking for buyers later, rather than finding the buyers and building later. This strikes me as a risky way of doing things.

Debt-to-Equity Ratio: The book calculates this as long term debt divided by shareholder’s equity, but I am going to include both long and short term debt, because it is trouble in getting maturing debt refinanced that brings companies undone (think Centro, a company now virtually owned by its banks). A low ratio is good because debt payments have to be met and, as stated above, banks get nasty when businesses miss payments. A low ratio also indicates that a company will be able to raise debt easily if they need it.

For Nomad, we get the following results:
FY2008 32%
HY2009 42%

Its hard to assess what constitutes a “low” debt-to-equity ratio without comparing companies across an industry, but a jump from 32% up to 42% cannot be good. Looking at the details we see that debt increased from $38m to $47m and equity decreased from $119m to $113m over the six months to 31 Dec 2009. So the cost blow out hit both sides of the ratio.

Return on Equity: net income divided by equity, ie the amount of money generated relative to the amount of money put into the company.

Here are the results for Nomad:
FY2007 28%
FY2008 20%
HY2009 before impairment of goodwill 15%
HY2009 after impairment of goodwill 2%

So with all their trumpeting about increasing revenue and net profit at 30 June 2008, they kept very quiet about the fact that their return on equity dropped a whole 8%. Meanwhile, the events of the last half of calendar year 2008 just made everything worse.

Having done all this I’m not feeling much confidence in the management of Nomad. They bought to companies that worsened their results and they have issues within their Nomad Modular Building subsidiary which they don’t appear to fully explain anywhere, not in the financial statements and not in ASX announcements. I don’t like the lack of transparency on this issue.

Nomad’s full year results should be released to the ASX this week (all companies have until the end of August to report), so I’ll be interested to see whether they have managed to turn things around, but they are not gearing up as a buy in my book.