When Your Assets Become Liabilities

How far will the market go down?

How long is a piece of string?

All we really know – and need to know – is the market is going down. But, the fat lady isn’t singing… She’s just clearing her throat.

But that doesn’t mean it’s too early to work out what to do when it’s time to strike.

Greg Canavan, the editor of Sound Money. Sound Investments, has told his readers for a while to make sure they’re holding cash. Enough to invest in value opportunities when they present themselves…

So how can you tell a good opportunity from a bad one in this market? The same way you always do…

You work out what a business is worth. And if there’s a big enough discount between the share price and its real value, the business you’re thinking of investing in could be a buy.

Two weeks ago we wrote to you about finding the margin of safety.

Today, it’s assets and liabilities: What they are… And how they can help you decide if a stock is worth buying.

An asset is something a business owns that brings money in. A liability is something a business owns that costs it money. If you’re going to invest in a business, you want one that is overweight on cash-bringing assets – not liabilities. It’s not the text-book definition. But it makes a lot of sense if you’re looking at a retail stock like Harvey Norman [ASX: HVN], for example.

Here’s a snapshot of Harvey Norman’s 2010 balance sheet…

Harvey Norman's 2010 balance sheet
Click here to enlarge
Source: Yahoo Finance

Its inventory is valued at $262 million. This is an asset. But if it can’t sell those TVs, fridges, couches, lamps – whatever – at the price it wants, they’re no longer assets.

They’re liabilities. Because they’re taking money away from Harvey Norman. And if the only way Harvey’s can clear that stock is to slash the prices by 60% on all those items, a $262 million asset becomes a $157.2 million liability…

And then there’s ‘net receivables’… The total money owed ($1.08 billion) by Harvey Norman customers who are paying off goods on the 24-months interest-free plan. But it’s nothing but a promise to pay. What happens if they die? Or default on their debts? Or Harvey Norman goes bankrupt before those debts are paid? Well, then ‘net receivables’ become a liability too.

For a company with a $2.1 billion market cap to only have $5 million of genuine assets (excluding ‘cash and cash equivalents’) on the books… well… there’s a reason its share price looks the way it does…

Harvey Norman Two-Year Price Chart
Harvey Norman Two-Year Price Chart
Click here to enlarge

 

Aaron Tyrrell
Editor, Money Morning

Money Morning Australia