Follow the money.
That's great advice whether you're trying to unravel political skulduggery or to separate stock market winners from wannabes.
Too many investors, though, think the money they should be following is earnings, the most familiar but also most easily manipulated of financial measures. The great financial crisis, which still has the world economy in its grip, should have taught us that companies can continue to generate fabulous earnings growth even as they rot from the inside.
If you want to follow the real money, concentrate on a company's balance sheet, the best single source of information about its health.
Right now, with so many companies still recovering from near-death experiences in the land of debt and leverage, watching balance sheets for the moment when a company goes from intensive care to the recovery room is one of the best ways to look for bargain-priced stocks that are on the mend.
Ford under the microscope
Let's take Ford Motor (F, news, msgs) as an example of what following the balance sheet can tell you about a company and about whether or when you want to buy its shares.Ford made the front page of business sections across the country Nov. 3 by announcing a startling $1 billion profit for this year's third quarter. The company generated earnings of 29 cents a share, a huge improvement over its loss of 7 cents a share, or $161 million, in the third quarter of 2008.
Other earnings numbers were just as impressive. For example, Ford's North American unit generated its first profit from operations -- as opposed to rearranging financial deck chairs on the Titanic -- in four and a half years. Overall, the company will be solidly profitable in 2011, Ford has told Wall Street analysts.
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Not until you look at Ford's balance sheet.
From that financial report you'll get a better idea of how much progress Ford has made and how much further it has to go.
Because Ford is the only one of the three major U.S. automakers to avoid bankruptcy, the company still carries the full burden of its debt. And a very full burden it is.
The company's liabilities will come to $38 billion in 2011, according to Barclay's Capital. That compares with just $22.3 billion for General Motors, which has been able to shed substantial debt in its passage through bankruptcy.
Indicative of Ford's newfound relative financial health, rather than drowning in that sea of red ink, the company will be able to refinance much of its debt. Ford has announced that it will raise $3 billion to pay down debt. The cash will come from a $1 billion offering of common stock and the sale of $2 billion in senior notes. The notes can be converted to common stock or cash in 2016.
A thumbs-up from creditors
What will Ford do with this $3 billion? It will use the money to pay down 25% of its revolving line of credit. That planned reduction, in turn, has enabled the company to persuade other lenders representing $6 billion on its credit line to extend the maturity of that debt from December 2011 to November 2013. In other words, rather than having to find the cash to pay off that $6 billion in a little over two years, Ford has put off the bill on that debt for an additional two years. (The company is negotiating to extend the maturity on the rest of its revolving line of credit, too.)
Video: Ford chief Alan Mulally on the company's future
What do the lenders get in return? A 1-percentage-point increase in their interest-rate margin, an increase in fees, an upfront payment and a 25% reduction in the amount that Ford can draw down on this line of credit.
All this means that lenders, who have an opportunity to do far more extensive due diligence than do individual investors, have given Ford a balance-sheet seal of approval. They believe the company is on the comeback trail, and they've backed up that belief by giving Ford a chance to strengthen its balance sheet. That, in turn, will make the company significantly less vulnerable if sales volume in the auto industry doesn't pick up again as quickly as everyone now expects.
Shares face dilution
I'd take that kind of balance-sheet improvement over an announcement of a one-quarter gain in earnings as evidence of a turnaround any day.
But this kind of balance-sheet analysis also convinces me that I don't want to buy Ford's shares quite yet. The company is going to issue 132 million new shares to raise that $1 billion in its stock offering. After the offering, current investors will own 4.1% less of the company. That degree of ownership will have passed to investors who buy the next shares. Until the stock sale, current shareholders will own all of the 20 cents a share that Standard & Poor's projects Ford will earn in 2010. After the sale, they'll own just 19 cents in earnings per share.
How important is that swing of a penny? Not very. Hardly enough to deter an investor looking to buy at $7.58 a share now.
But the difference does start to become significant if you believe Ford's $1 billion stock offering in 2009 won't be the last time the company has to go to the well. Even if Ford uses all the $3 billion it raises in cash to reduce debt, it will still have $35 billion in liabilities at the end of the process.
So investors who are encouraged by Ford's balance-sheet improvement have to ask themselves how many more times will they see their ownership of earnings diluted by 4% or more before Ford's balance sheet is reasonably solid.
Continued: A different look Down Under
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