by Lance Helfert

Here in California, many of us maintain earthquake kits to provide us with food, water, medical supplies and other necessities (like coffee!) to ensure our survival after a major quake. A strong balance sheet can be a company's survival kit after a credit earthquake. In good times (or even bad times that do not include a complete credit freeze), good companies can find capital at reasonable terms. In horrific times such as the present, even great companies struggle to secure capital. 2010 bonds for Wrigley (now part of Mars, Inc.), which is not struggling for capital, yield nearly 10% today!

Companies with overcapitalized balance sheets not only avoid credit squeezes - which can permanently damage equity value as a result of dilutive financing - but they are also able to prey on the weak and acquire other companies at incredible fire sale prices, especially in difficult times like these. This is a double edged sword, as leveraged companies often appear cheaper, and in normal credit environments investors expect that financing will not present a big obstacle.

One important balance sheet caveat: Cash is important, but it is less important than the hands that wield it. Cash should be deployed to increase value. In the wrong hands it can lead to stupid acquisitions or other bad investments. Know management's history vis a vis disposition of assets. Also, as many learned in 2008, cash is not always cash. Many companies invested in Auction Rate Securities (ARS), many of which turned out to be worthless even though they were "cash equivalents" on the balance sheet.

Many California households only boast fully stocked earthquake kits for a few weeks after a small temblor. Over time, family members raid the kit for canned goods or flashlight batteries. Then, in a real emergency, they find themselves unprepared. Keep an eye on the balance sheet to ensure that the companies you own will have options available when trouble comes. 

Lance Helfert is co-founder and president of West Coast Asset Management, and a co-author of The Entrepreneurial Investor: The Art, Science and Business of Value Investing. This blog entry is an excerpt from West Coast Asset Management's monthly newsletter, Exclusive Outlook.