How to Analyze a Balance Sheet

In this podcast, Motley Fool analyst Jim Gillies joins host Ricky Mulvey for an in-depth look at how investors can understand a company’s balance sheet. Heads-up: This show gets to some more advanced concepts than our usual fare.

They discuss:

• The basics of balance sheets.
• If Lululemon has an inventory problem.
• A cautionary tale from a mattress seller.
• Companies with strong balance sheets, (besides Berkshire Hathaway).

Check out The Motley Fool’s Dictionary of Financial Terms to learn more.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our beginner’s guide to investing in stocks. A full transcript follows the video.

This video was recorded on Sept. 01, 2024.

Jim Gillies: A balance sheet, Ricky is just a moment in time. It is, what is the financial position at this moment in time? I think from a more comprehensive analysis of the balance sheet, you should have multiple balance sheets. You should be looking across quarters. You should be looking across years and see how things have changed.

Ricky Mulvey: I’m Ricky Mulvey, and that’s Motley Fool Canada’s Jim Gillies. He joins me on today’s show for a class on balance sheets or how investors can understand what a company is keeping on its books. We’ve also got an in depth look at Lululemon and some stories about the company beyond its surface numbers. At the end, we’ve got some under-the-radar companies with strong balance sheets. A few notes before we get started, I want to let you know this show gets to some more advanced concepts than our normal stuff. You also might notice that Jim’s audio clips a bit, and we’re also off on Monday for Labor Day. Hope you’re having a good long weekend, and we’ll be back on Tuesday.

Jim, balance sheet Day has finally arrived. I think we’ve promised this on what is it? Like, two or three weekend shows now, but we’re finally here. No more stories about Nortel Networks. We’re going straight to the balance sheet. I think a good place to start for this is just to walk through your process when you’re maybe checking out a company, when it’s going through your process, what are the balance sheet checks that you’re doing?

Jim Gillies: Sure. There’s a number, and a lot of them are actually the financial statements work together. You really can’t focus on one because you’ve got to bring things in. While you are looking at the balance sheet, you’d be looking at the amount of debt a company has got, the amount of cash a company have got. You can check the different individual accounts, but you start getting into things like leverage ratios. That’s starting to mix the balance sheet with the income statement. You’re comparing debt, the total debt to a profitability metric like EBITDA. If you’re selling physical goods, even if you’re not, but it’s easier there. You want to look at things like turnover ratios. These pull in things like from the income statement, like sales or costs of goods sold.

It’s a means of heading toward a very balance sheet heavy metric called the cash and conversion cycle, which we’re going to get into a little bit, that talks about things like days sales outstanding, days inventory outstanding, days payables outstanding, which are all basically working together as a metric or, I guess, metrics for the efficiency of a company. I also like to go through the balance sheet. You’ve got your two sides your assets and your liabilities plus equity on the right side, on the left side with assets. I always like to go through the assets and try to answer for myself how real is this asset? How dubious is this asset? Assets are organized on the left hand side of the balance sheet according to their ease, and these allegedly, according to their ease of conversion into cash. That’s why you see cash at the very top and that’s generally why you see things like goodwill or deferred tax assets or company specific intangible assets near the bottom of the balance sheet because they likely have very little, if not, zero value to anyone besides the company in question and maybe [laughs] not even then, considering the history of writing off goodwill several years after you paid for it is not short.

I came here with a bit of a case study. It’s a company called Kneat.com. It’s a Canadian company, KSI, on the Toronto Stock Exchange, I think, really not important, but this is a company that does software for basically data management in the pharma industry. The company looks free cash flow positive, and maybe they have a cash flow negative for the longest time, but when you factor that they are capitalizing just the vast majority of cash they generate as their own personal intangible asset. In the most recent balance sheet, I think they had about 87 million in total assets, but close to 32 million of that is just the company generated intangible asset. Now, they can’t sell that to anyone. They can’t monetize that anymore. The only way they’re ever going to get any value out of that, any cash value from that is if the entire company gets taken out. Ask yourself, how real are these assets? Mainly because in the event of a solvency crisis or a liquidity crisis, Availability of cash is really important, and you don’t need it until you need it if you catch my meaning.

Ricky Mulvey: I heard Ohio State finance class, Professor Sheridan, liquidity is oxygen. You don’t realize you need it until you really need it.

Jim Gillies: Yes.

Ricky Mulvey: Real quick on that. I don’t understand the capitalizing on an intangible asset and how that affects the free cash flow.

Jim Gillies: The money has spent out. Since we’re going down, we’re supposed to be the balance sheet today, but we’re going to go to the cash flow statement.

Ricky Mulvey: They all connect. I got to title that show somehow.

Jim Gillies: There you go. We’re on the cash flow statement. There are three sections to the cash flow statement. The operating cash flows, investing cash flows, financing cash flows. The funny thing is, financing cash flows are largely prescribed. You’re raising of capital, you’re paying off of debt, you’re buying back stock, preferred stock, if you want is in there as well, but it’s fairly fixed and narrow. Investing cash flows are fairly fixed and narrow. It’s capital expenditures, but maybe you sold some assets, so you get some cash back from selling some PP&E, recognize spending on intangibles and what have you. Everything else lands in the operating section. It’s the dumping ground of the cash flow statement, which is funny because, when we talk about free cash flow, the simplest definition is operating cash flow, what I’ve just called the dumping ground, operating cash flow, less Capex.

This company here that I’m talking about right now, net.com. They really don’t have any Capex. The Capex budget is very low, but all of that money is being spent on the intangible assets. A free cash flow, a very simplistic or someone who’s just running a screen, doing operating cash flows Capex, they’re going to think this company is far more profitable than it actually is or far more cash generative, I should say, than it actually is because they are ignoring the spending on intangibles. In this case, you have to understand the type of company you’re looking at. That is what they’re doing for Capex effectively. They are spending on this self generated data management asset that again, might have a little dubious value to anyone but them.

If they can sell the company for more than it’s worth today, great, when and if they ever choose to sell it, but as valuing it on and ongoing free cash flow basis, be very disappointed because the cash flow is not actually free cash flow is allegedly the amount of cash available for you to deploy in one of the classic capital allocation ways, dividends, buybacks, payoff debt, invest for growth, acquire other companies thing. This company doesn’t have it, but a quick cursory look might suggest they have it. Anyway, that’s the quick answer. Back over on the balance sheet. This the last thing I wanted to talk about before we move along in our conversation is assets can have dubious value like I talk about, so you want to be aware of that. Funny thing is, liabilities are typically worth a dollar for a dollar. People like to get paid back, and they don’t tend to want to take a haircut and if they have to take a haircut, they’re probably going to make your life pretty miserable.

Ricky Mulvey: Let’s break this down because I know we’re not doing the growth versus value investor thing, but when we’re looking at a young company with a lot of sales growth, inching its way toward profitability, maybe, what should I be looking for in the balance sheet? In this case is like a quick ratio meaningful, how much cash it can pay folks.

Jim Gillies: Yeah, I’m not a big fan of the inching toward profitability. In that case, if it profitability is an accounting construct, cash flow is a more real construct, at least the way I look at things. I would tend to say, if inching toward profitability, let’s just loop a inching toward cash generation as well. Marry the two concepts. In that case, I want to know how much cash they have. I want to know how much unencumbered cash they have. A quick ratio for those who don’t know. The quick ratio is basically the very readily or at least theoretically readily monetizable assets on the asset side. Again, organized top to bottom for ease of cash conversion to the worst. You’re taking your cash, you’re taking your short term investments, you’re taking your accounts receivable. You might be hair cutting your accounts receivable, maybe say, $0.75 on the dollar. But you add those three things together and divide by all current liabilities. The various places you want to read your finance textbooks or whatever, we’ll say, you want to have this at least 0.75. You want to at least because you want to know, you’re not going to have to pay all your current liabilities immediately, but you want to be able to at least know you can hit 75. Above one is better, above 1.5, better still. I did come with a case study, but it’s not inching toward profitability. It’s actually a really it’s a pretty impressive company.

Ricky Mulvey: It’s a growth company.

Jim Gillies: I listen to the high growth part of things, but not so much the inching toward profitability, but a Wingstop. Wingstop, five-year revenue growth, 25.5% annualized, the last year of revenue growth, 32%. Profitability is more than fine. If you wanted to pick on Wingstop, it would be the valuation. This is an expensive wing joint. But they’re quick ratio, just taking cash plus short term investments. They don’t have any, but just non restricted cash plus the net receivables, they’ve got a quick ratio about 1.33. However, as part of their deal, they take cash flows from all their stores, and it goes into an advertising fund, and that is a restricted it’s about $31 million, I think in the last balance she had looked at. It’s about $31 million. It’s both a restricted asset account that is money that is earmarked to be spent on advertising, but they’ve also got a corresponding equal amount liability. That liability pops up in our calculation or it’s included in our denominator calculation for the quick ratio, but I’ve excluded it from the numerator calculation.

I would argue, based on looking at balance sheet, that this is fair to exclude that from current liability. We’re already adjusting the current ratio because as they spend for the required advertising fund that makes up the liability, they will absolutely be spending out of the restricted asset that they’ve gathered for to offset that liability. I would say it’s actually fair to throw them both out. At that point, the quick ratio jumps from 1.3 to about 2.14, which is then, even again, it shows that in the immediate need for cash here is probably not high. They’re more than capable of turning it over quickly. What I do get more interested in is a balance sheet, I’ve already mentioned it, but is the cash conversion cycle and it’s actually been slightly negative at Wingstop for the last five years. Last year, I think they were slightly positive. It’s not a big deal. This is the takeaway as always we can all look at numbers, we can all calculate numbers. What is the takeaway? What is the implication of the numbers? I look at the cash conversion cycle at Wingstop, and I see how low it’s And I say this is a very efficient business, which is probably good because their inventory, of course, is overwhelmingly raw chicken wings, which don’t exactly keep that long.

Ricky Mulvey: Unless you freeze them. Got you. Let’s do cash conversion cycle, while we’ve mentioned it a couple of times. Why is this meaningful to you? What does it tell investors?

Jim Gillies: It’s an efficiency metric. It basically takes the major working capital accounts, accounts receivable inventory, accounts payable. You might want to bring accruals, but from the balance sheet. Then it also brings in some select sales related accounts from the income statement. You start with what are called turnover ratios. How fast do we turn over the balance on the balance sheet? Accounts receivable turnover is a sales divided by your average for the period. The average accounts receivable inventory turnover is the cost of goods sold from the income statement, divided by the average inventory during our accounting period. The account payables turnover is purchases. Now, we don’t have an account for purchases on the income statement.

But all purchases is, is the cost of goods sold from the accounting period, plus the ending inventory, minus the starting inventory, divide that by the average payables for that period. Then to go from the days outstanding for each of those turnover ratios, we just divide 365 by the respective turnover. Days sales outstanding is 365 divided by account receivable turnover. Days in inventory, 365 number of days of the year, 365 divided by inventory turnover. Days and payables, 365 divided by the accounts payable turnover. Then the cash conversion cycle, I’m sorry for those trying to write all this down. Trust me, Wikipedia has got an entry. The cash conversion cycle is days sales outstanding, which is tied to receivables, or it’s tied to sales and receivables, plus days and inventory, which is tied to cost of good sold and inventory, minus days payables outstanding. That is the basic number, and you want to see how things have moved over time. Different businesses, different companies will have a different base level cash conversion cycle. I’ve already mentioned, Wingstop because their inventory is chicken wings, and they’re going to want to move those in and out as fast as possible. You don’t want to have chicken wings on ice for the next six months.

You’re going to see the day’s inventory low if it’s a well run efficient company. You’re going to see day’s sales outstanding very low because you’re paying instantly. Your credit card over and you get your wings. Then payables as how quickly do they pay the payables? The fact that it is slightly negative to maybe one day or less positive over the last five years should not be surprising, where I would be concerned. Again, balance sheet Ricky is just a moment in time. It is, what is the financial position at this moment in time? I think from a more comprehensive analysis of the balance sheet, you should have multiple balance sheets. You should be looking across quarters. You should be looking across years and see how things have changed for better, for worse over those time periods.

Ricky Mulvey: What would be on the cash conversion thing, and I promise we’ll go to Lululemon in a sec? Then when would the cash conversion cycle number be a warning flag for you?

Jim Gillies: Well, I was going to say, once we get to Lulu, I’m going to give you a yellow flag. Let’s do Lulu, because I can tell you there’s a yellow flag that I would think about with Lululemon.

Ricky Mulvey: Look at that. We’re doing a tease middle of the show.

Jim Gillies: A segue.

Ricky Mulvey: We’re recording this before Lululemon reports. I’m going to use the previous quarters numbers. I think their balance sheet has just some weird things going on with it. I don’t know if it’s good or bad. But for example, one thing, it’s building up its cash base. It has nothing in short term investments. Now, if you’re a CFO of a company, you can get an easy what is it 4 or 5% by getting some treasuries. That’s what the Berkshire people are doing. I’m thinking, like, why are you doing that? You’re giving me a shrug emoji.

Jim Gillies: You have to ask the CFO. I would agree. They’re not making as much interest income as they probably could beyond that, but maybe they figure they just want to be more conservative and have that nearly 2 billion in cash. They’ve got 1.9 billion, I guess. They want to have it available as quickly as possible. I don’t know.

Ricky Mulvey: Here’s one that I do not understand. Lululemon spends $0 on interest expense. It’s also got 250 million in short term debt, 1.5 billion in long term debt. I thought those things came with interest. I do not understand how this is possible.

Jim Gillies: Here I’m going to apologize to the listeners. If you thought we were already in the weeds, we were about to start tunneling. They actually have zero debt. What they have, I know this is, it’s not debt per se. What they have is operating leases. In other words, they rent their stores. They’re paying rent every month to their stores or wherever their store fronts are. This stuff used to be leases, operating leases used to be carried off balance sheet. They weren’t on the balance sheet. They would just have a rent expense that would flow through the income statement every accounting period. Then a few bright wags said, well, an operating lease is contractual payments over a certain period of time. Boy, that sounds like debt. Operating leases probably should be thought of as debt equivalent. Hey, we’re going to require you to capitalize all your operating leases and stuff them on the balance sheet. What you end up doing is you have, and they change the accounting rules to require those.

I will say this doesn’t change the cash flows of company at all, by the way, but OK. Now you have to have the present value of lease payments as a liability, operating lease, present value equivalent to perception of debt. You have offsetting what’s called a right of use asset on the asset side of things, which is just the store that you’ve got leasing. This can be a topic for a bit of debate. The Godfather evaluation, Professor Aswath Damodaran will shake his head disapprovingly in my direction, and that’s fine. I disagree with operating leases as debt equivalent because, again, these are rent payments. Are you going to staff those stores, Ricky? You going to have people working in those stores to service people?

Ricky Mulvey: Unless you get the self checkout thing going on. You go to overseas to have you watch you on cameras.

Jim Gillies: Maybe. You going to pay those people?

Ricky Mulvey: Hope so.

Jim Gillies: Cool. Why aren’t we capitalizing those operating costs? Why are we capitalizing rent but not employee wages and benefits?

Ricky Mulvey: You got me.

Jim Gillies: Well, I’d just like, and also too, take a 10 year lease into a bankruptcy court and see how many months they give you credit for. Hint, it will not be 10 years. You might be lucky to get one.. Anyway, so what you’re seeing in Capital IQ on that debt is actually just the present value of operating leases. Operating leases actually when you capitalize operating leases, the rent payment that you’re making ends up basically splitting into two components. There is a depreciation or amortization of that pseudo asset you’ve got or the value of you’re going to be taking it down. Then there’s a component that we’ll call implied interest. But again it’s a little dodgy. You can work this out. I did put an example in our notes, but I’m not going to go through that because it’s a pain in the neck. But essentially, if you wanted to evaluate a company with a lot of leases, the end result is you’ve got to add back the implied interest expense to operating income or EBIDA to get a better amount. Then you got to change the amount of debt. I’m sorry I understand the logic behind capitalizing operating leases and treating them as debt equivalent. I just don’t agree with it.

Ricky Mulvey: Let’s go on to the inventory, because this is one where I’m a Lululemon shareholder. It’s something that I’m taking a look at. Last year, Lululemon leadership saying. There you go. Basically saying, hey, we’re going to get inventory under control. We’re not going to use a bunch of discounting to get rid of it. This is also a time where sales growth, particularly in North America, is slowing down. They got 1.4 billion in inventory, and I know how much you like numbers in isolation. But to me, it’s a sign as I see that continuing to rise from 2022 to today that they’re struggling to get that under control. Is that a yellow flag to you?

Jim Gillies: That is the yellow flag I was referring to when I was talking about the cash conversion cycle, because a number in isolation is just that. A number in isolation doesn’t tell us anything. However, again, think about the business that we’re working through here. They get their cash almost immediately. Again, cash conversion cycle, days sales outstanding, plus days inventory outstanding, less days in payables. What you’ve seen here. Day sales outstanding is actually very small because they get remittance from the credit card companies almost immediately. Day sales and inventories is very little number.

The big numbers can be how many days are in inventory or how quickly, if you again, go back to the precursor ratio, that would be inventory turnover. How fast they turn over all of the inventory that flows through the business in an accounting period, typically a year. I can tell you Lululemon a decade ago, was turning their inventory about four and a bit times a year. About once a quarter, the entirety of the inventory balance is flushed through the whole company. Today, they’re below three. When we look and we crack the numbers for the cash conversion cycle at Lululemon. We find that from 2013 through 2019, it was clipping along in the ’80s. There’s some variation and that’s fine. It was going 80-85-82-84-83. I was clipping along in the same era. 2020 and 2021 starts to bubble up to the low ’90s. Lower is better Fools, or lower indicates more efficiency. 2022, it went to 107 days. 2023 goes to 106 days. This is definitely trending in the wrong direction. Then you break out again, the three components, days sales outstanding, days inventory outstanding, days payable outstanding. The payable is the offset.

You’re adding the first two and deducting the third. Days payable outstanding over the last decade we’ve talked about, it was in the load a mid single digits. They were paying payables pretty quickly. The last four years, it’s averaged about 24 days. They’re pushing on their vendors a little bit, not paying them as quickly as they previously were. That can be OK, if you’re Lululemon, you’re the big dog running around in athletic wear, you could maybe lean on your suppliers a little bit. There’s nothing wrong with that if you can get away with it, but I’m going to point out that payables going 4-24 days roughly in the past five years. That’s an offset to the day sales plus days and inventory. Again, throw at the day sales because it’s very little here. That’s masking some of the problems with the inventory. That days payable rising is masking some of the problems of inventory rising faster. The days inventory was a decade ago, 85 days. Today, it’s about 126 days. One way to reframe that and think about that because again, what is the takeaway? Whenever we talk about numbers, the numbers are the numbers. What is the implication? What is the takeaway? You can suggest. I’m going to suggest that what this number says, days and inventory going 85-126, and really the last couple of years is really pushed up. The efficiency of the business, the efficiency at which Lulu moves inventory through its system has fallen by about a third. It’s fine for you to tell me you’re not going to discount anything. God bless. This number says, you might have to discount something if you want to start moving the stuff. But if you are seen to be discounting and moving, you then run the risk of impacting your premium branding. It’s potentially complicated.

Ricky Mulvey: Another part of the balance sheet that is interesting to me. This is a company with $24 Million in goodwill, zero bucks in intangible assets. They got a pretty strong brand. That’s got to be, like Lululemon has to be worth more than zero or $24 million. There’s another one. Don’t understand it.

Jim Gillies: Well, that’s because they’re lying to you, Ricky.

Ricky Mulvey: Cool.

Jim Gillies: Good. Let me make my case. First off, you don’t just get to pick an asset value for your brand on the books. You don’t get to go make up a thoroughly reasonable. I would agree with you. The value of the Lululemon brand is substantially worth more than zero. It’s probably in the billions to be honest with you. What would someone else pay for that? I’m going to suggest they’re going to pay more than zero, and probably significantly more than zero if you wanted to buy. Of course, if someone did buy Lululemon the company, they would, as part of that acquisition, allocate the purchase price across the various assets, both tangible and intangible. They would allocate the price among those assets. That would include the brand names acquired.

If someone were to buy them, Nike comes out of nowhere and buys Lululemon, Nike will then put a value for their purchase price on the Lulu brand. But because Lulu has grown its brand since inception and given the inherent conservativeness of accounting, at least the supposed inherent conservatives of accounting. That’s a whole other show. You don’t just get to make up a value and stick it on the books. Also too as the company grows and gets better or worse, do you take gains or losses and flow them through the income statement? It’s not cash anyway. That is, I think, a little bit distracting. However, here is why I say Lulu is lying to you. I’m doing a little deliberately provocative, because you are right. They have 24 million in goodwill and zero and intangibles. But I was there when Lululemon bought Mirror for $500 million in June of 2020. I remember seeing it. That acquisition. Go ahead.

Ricky Mulvey: I was just going to set it up. Mirror was basically, I’ll say a pandemic story. It was literally a mirror you put in your house, and then personal trainers and workout classes would come to you, and then you would work out in the comfort of your home with basically a big TV/mirror on the wall.

Jim Gillies: It’s what if Peloton had a baby with the mirror of Era said from the Harry Potter Universe. [laughs] There’s no one else is ever going to make that one. It was a really weird acquisition, but they paid half $1 billion for it. Of that half a $1 billion, 85 million was allocated to recognizable intangible assets, and 362.5 million was allocated to goodwill. Yet you’ve just told me the balance sheet, and I have confirmed this, the balance sheet has only 24 million in goodwill, and we do not amortize goodwill any longer, and zero intangibles. What has happened with the Mirror acquisition? The answer is it’s almost they amortized about a third of the intangibles they initially allocated to the Mirror acquisition and wrote off the other two thirds. In 2022, they wrote off 100% the entirety of the goodwill that arose from the Mirror acquisition. I’ve not seen a more efficient way of setting half a $0.5 billion fire, but Lululemon managed to do it. All that said, I don’t get terribly worked up when I see goodwill on the balance sheet. That’s a starting point. I then go back and look and see what did that goodwill arise from. If it is something like this. I will give full disclosure. In June 2020, when Lululemon bought Mirror, I thought it was a bad deal at the time. I believe I said on Motley Fool live. This is a goodwill impairment write off waiting to happen. I thought it was a really bad acquisition.

Jim Gillies: But you want to go back and see what acquisitions caused the goodwill and see how things have progressed since then. Because, of course, in the first couple of annual reports after they acquired mirror, if you dug into the notes to the balance sheet and the financial statements, they’re like, everything’s fine, we don’t need to do any impairments. Then, magically, write the whole thing off, call it a day.

Ricky Mulvey: I will assume that if you are at this point in the podcast, you’re one of the hardcore investing nerds. We’re going to finish it off with two things. One is a balance sheet story, and then the second we’re going to do is maybe some companies with some sneakily strong balance sheets. One we’ve talked about a lot in pre interviews but I don’t think we’ve done it on the show is Sleep Number, the [inaudible]. This is a company that has $2 million, and I know we don’t do numbers in isolation. [laughs] It has $2 million in cash in $106 million in accounts payable. That seems bad, Jim.

Jim Gillies: It’s worse than you’ve made it out to be actually.

Ricky Mulvey: Really?

Jim Gillies: Yeah. Sleep Number, formerly known as Select Comfort, Ricky is correct. We have talked about this, but I don’t think we’ve done it on the show. Let’s do it. They are one of my favorite cautionary tales because this is actually a rerun. Larry did this once. They blew up their own balance sheet via buying back their own stock. Apparently, someone in their corporate finance department read a simplistic headline that probably wrote out as buybacks is returning cash to shareholders and never read past the headline. I’m going to go back about two decades from 2002 through 2006 when they were still known as Select Comfort. They made a ton of cash, pot on their debt free balance sheet, I will put it that way, Ricky. Then around 2005, they started buying back their own stock, because don’t you know, buying stocks, returning cash to shareholders. If my sarcasm is not coming through I can amp it up a little bit more. They accelerated in 2007. They blew the entirety of their cash balance, they’d taken years to build up on buybacks.

Then they kept going anyway, and they put additional buybacks on their credit line. Then the world turned and growth slowed. They had what’s called a negative cash conversion cycle. That means the inventory is sold before you actually pay for it. It’s a wonderful balance sheet trick if sales are growing. Dell computer back in the day was famous for this. You would make the order and pay for it online, they would have your cash, and then they would order the parts to assemble your computer and ship it to you.

They would push off their payables by 30 or 60 days. What it effectively amounted to was a 30-60 day interest-free short-term cash loan that they would finance their business with. Select Comfort was like that or Sleep Number Bed, if you prefer. Unfortunately, in 2008, when the world was ending, of course, in credit crisis, and these guys sell beds, I’m sure it’s not tied to housing stats or anything. Their sales rolled over, their negative working capital became an anchor rather than a boon to them. Basically, the company turned free cash flow negative. Remember how they blew all their cash? Sounds like right now at $2 million in cash, don’t it? They blew all their cash on buying back their own stock and went into debt to buy back more of their stock and now their stock is rolled over. Long story short, free cash flow negative, more debt on the balance sheet in cash, stock falls 90 plus percent. They had to sell a bunch of shares in a vulture financing move at like 80-90% off of what they had paid for them. Just brilliant capital allocation. You think that would scar them a little bit? But nope, not our plucky heroes Sleep Number.

They decided to do this again and do it bigger. I know, I’m just being a nasty letter from them. But from 2012 through 2022, 11 years, they spent $1.6 billion on buybacks. I say only, they only produced about a cumulative billion dollars in free cash flow during those years. How they square that circle? Well, of course, they put the rest of it on debt. They did it again. Stop me if you’ve heard this before. Free cash flow turn negative. They’ve just barely turned cash flow pause in the first half of 2024 to the tune of about $9 million. Trying to throw that against debt now, big deal. Because in addition to the 106 million in payables you mentioned, they get $540 million on a credit line that matures in about 2.5 years on which they’re paying 8.4%. This was easy to see coming. The company had their own history as a warning case study and they blew it up again anyway. Ironically, they still have a negative cash convergence cycle. They should be able to make some progress if and only if air bed sales rebound, and they put some of that cash to work. Wouldn’t it be a lot better to be buying back stock today at 14 rather than 114 they were paying a couple of years ago? The solution here is, I expect what they’re going to have to do is they’re going to have to do what they did last time. They’re going to have to sell a Wacker stock at a far lower price and then they were buying it back at just to fill those hole. The entire finance team involved with this should lose their jobs frankly, and throw the CEO too, this is appalling management.

Ricky Mulvey: If you’re going to get a mean letter, you might as well just go all the way on it, Jim.

Jim Gillies: I’m just saying, how did you do this a second time?

Ricky Mulvey: We’re not ending the show there. We’ve talked about a pharmaceutical software company with some weird free cash flow stuff. We talked about how Lululemon is getting less efficient, and we’ve got a cautionary case study. All of that’s negative. But it’s more interesting to do that than just say, that company has a great balance sheet. But I think that’s where we should end it, the payoff. If you’ve been listening this long, we should get some companies to look at with strong balance sheets, not just cautionary case studies. When we think of bulletproof balance sheets, Berkshire Hathaway is the one that comes to mind immediately, basically 280 billion rounding in cash and equivalents enough to buy the vast majority of the S&P 500. We’re going to set that aside, that one’s known. To finish off, what are some companies that you follow maybe with a sneaky strong balance sheet?

Jim Gillies: Sneaky strong doesn’t necessarily translate to good shareholder returns, although sometimes it does. I’ll give you the negative one first just so we can finish on happier. For example, Cato, which is a retailer, mainly in the American Southeast, have zero debt, have more cash on their books than the company’s market cap. It’s literally the business, if you strip out the cash. They’ve also got some hidden assets, they’ve got some owned land, they bought at a bankruptcy, so the value of the land that’s on the books is very low, but they’ve hived off a couple of pieces of it over the years and sold it for considerably higher than the percentage that they would have recognized in the bankruptcy purchase.

The problem is the CEO/controlling shareholder seems at best disinterested, frankly, and so the stock is down two-thirds in value over the past couple of years. Boy, it’d be nice if John Cato decided to actually focus on his business. But that one’s a backhanded compliment. Here is an interesting one, and it’s a lot of people are going to probably throw this one out, but I’m going up from the bottom of my notes here, we’re going to finish with the super strong ones. But this is interesting one. Check the online, basically, student outcomes, tutoring service. A lot of people think it’s going to get killed by AI, they’re trying to bring AI into their business. It’s imploded in the last few years and then their balance sheet. They got more cash than debt on their balance sheet. They’ve been buying their own debt back at a substantial discount, not in the most recent quarter or two, but before that. They got more cash than debt, and they’ve guided that they will have, “at least $100 million in free cash flow in 2025.” If they do that, and that might be a big if, but if they do that, the stock is presently trading at two times free cash flow. Seems cheap to me. A couple that I really like, there have been long-term, excellent compounding stories that have more cash than debt, and very cash generative.

Names you’ve heard of eBay. Yes, I’m serious, eBay, the second largest non-Chinese eCommerce portal even today, after no points, if you can figure out who the largest one is. Some river in South America. Costco has a fantastic balance sheet, more cash than debt, and a great many other things that should make you love Costco. Sprouts Farmers Market, the next Whole Foods, if you will. They just eliminated their last remaining true debt, they do have some leases like we’ve talked about, but those are not debt equivalent in my book, because you’ve got a lease of space to have your store. They make a lot of cash, they’ve got a really rock solid balance sheet, Academy sports and outdoor, same drill, slightly more debt, but lots of cash, and then it wouldn’t be a show with me on it if I didn’t mention Windmark and Medpace. You can throw them into. Medpace did the anti-Sleep Number. When their stock got cheap, they went out and bought back 13 or 14% of the company, including exhausting all of their cash hoard and going into debt, except, they did this really unique thing. Once the stock price went up, they stopped buying back their own stock and paid off all their debt, so they’re back to being a debt-free balance sheet with $0.5 billion in cash on it. It’s funny how that works out.

Ricky Mulvey: Here you go. Some companies to learn from, some stocks for your radar. Love it, Jim Gillies. Thanks for the class. I’ll call it a master class. Appreciate your time and your insight. Thanks for being here.

Jim Gillies: Thanks, Ricky.

Ricky Mulvey: If you’ve got any feedback on today’s show, or maybe you’ve got an investing class you’d like to hear, shoot us an email at [email protected], that is podcasts with an s @fool.com. As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don’t buyer sell anything based solely on what you hear. I’m Ricky Mulvey. Thanks for listening. We’re off on Labor Day, we’ll see you on Tuesday.