The Motley Fool: Look closely at the company balance sheet

Long-term investors should study companies’ balance sheets to see how sturdy the underlying businesses are, and whether their financial health is improving or failing.

For example, consider Wal-Mart’s balance sheet for the fiscal year that ended on Jan. 31, 2007. We see $7.4 billion in cash and cash equivalents, up 15 percent from the previous year. A growing pile of cash is generally promising. (Some companies have so much cash, though, that it would make sense for them to start paying or increasing dividends if they can’t come up with a better use of the money.)

You usually want to see little or no debt. Between 2006 and 2007, Wal-Mart’s total debt rose just 1 percent, totaling $39 billion. The smallness of the increase is good, but that’s a sizable level of debt. Still, there’s enough cash on hand to pay off most of the short-term debt (due within a year). A peek at the footnotes reveals debt interest rates. Low rates suggest the firm is financing operations effectively.

Next up, inventory. Wal-Mart’s grew about 5 percent, to $33.7 billion in 2007. Rising inventories can indicate unsold products languishing on shelves, but since sales rose roughly 10 percent year-over-year, inventory appears well under control. (Ideally, sales growth should outpace inventory growth.)

It’s also good to measure inventory turnover, reflecting how many times per year the firm sells out its inventory. Take 2007’s cost of goods sold (from the income statement) of $264 billion and divide it by the average of 2006 and 2007 inventory ($32.9 billion). This gives us a turnover of 8.0, up from last year’s number of 7.8. The higher the number the better, so this is a promising trend.

Accounts receivable represent money owed to the firm. Ideally, they shouldn’t grow faster than sales. Wal-Mart’s rose by 6.7 percent. A drop would suggest that it’s increasingly getting paid on time due to its clout.

You’ll find balance sheets at most major companies’ Web sites, among financial statements in the Investor Relations areas.

Ask the Fool

Q: With penny stocks, I can buy more shares per dollar than I can with more expensive stocks. Then, when the shares go up, I’ll make more money, right? — C.F., Erie, Pa.

A: Watch out. It’s a common misconception that penny stocks are a bargain because you can buy so many for so little. Remember that both a 60-cent stock and an $80 one can go up (or down!) by, say, 5 percent in one day. For the 60-cent stock, that means a 3-cent increase, to 63 cents. For the $80 stock, it’s a $4 jump, to $84.

Penny stocks are more likely to eventually plummet than to skyrocket. They’re risky, often hyped and manipulated by ne’er-do-wells. Steer clear and look instead for stock in healthy, growing companies you understand. In the last five years, you could have doubled your money on shares of Target, and you could have more than tripled it with Boeing stock. You’d have lost nearly 20 percent on Sara Lee stock, but even that beats many penny stocks, which might have left you with mere pennies. It’s fun to own 5,000 shares of something, but not when they crash — as they often do.

My dumbest investment

When I started investing, I used to trade in small quantities, such as 40 shares of Microsoft or 11 shares of China Life. I finally realized that the trading cost was eating away at my gains. Poor me! — M.V., via e-mail

The Fool Responds: You were smart to figure that out. If you’re investing, say, $500 in a stock and are paying your brokerage $50 to do so, you’re forking over a whole 10 percent of your investment from the get-go. We recommend aiming to pay no more than 2 percent of each investment in commissions. You can do that by waiting while you accumulate more money to invest at one time. If you invest $2,500, for example, and pay a $50 commission, that’s 2 percent. You can also simply seek out a brokerage that charges less per trade. These days many good brokerages charge less than $15 per trade.

If you’re in the market for a new brokerage, learn more at www.broker.fool.com and www.sec.gov/investor/brokers.htm.