Understanding Companies Part III: Interpreting the Balance Sheet

Understanding Companies Series: I. The Famous Accounting Equation In the first two articles, we examined a company’s “blood” (cash flow) and “muscles” (profits). In this article, we delve into the deepest—and most unforgiving—layer: examining the company’s “skeleton” and “foundation” (assets and liabilities). In bull markets, everyone focuses on the income statement, because it determines how high the stock price can soar; but in bear markets or crisis periods, only the balance sheet determines whether a company will survive—or go bust. As Warren Buffett famously said: “Only when the tide goes out do you discover who’s been swimming naked.” The balance sheet is that X-ray image revealing who’s wearing swim trunks—and who’s truly naked. To read this statement, you must first memorize the fundamental accounting equation: Assets = Liabilities + Equity Colloquial translation: What I own (left side) = What I owe (top right) + What belongs to me (bottom right). As value investors, we don’t merely count asset quantities—we rigorously assess asset quality. On paper, ¥100 million may look identical, but if it’s cash, it’s “provisions”; if it’s unsellable, outdated inventory, it’s “garbage.” In times of crisis, their fates diverge dramatically. II. Left Side (Assets): Distinguishing “Flabby Fat” from “True Strength” The left side of the balance sheet lists all resources owned by the company. But remember: not all assets are beneficial—some generate profits, while others are depreciating time bombs. 1. Cash-like Assets: The Bedrock of Survival Cash and cash equivalents are a company’s oxygen. Holding sufficient cash is common sense. Yet in China’s A-share market, beware of an illogical “ghost story”—the “dual-high” phenomenon of simultaneously holding massive cash balances *and* large loans. • Red Flag Warning: If a company holds ¥10 billion in cash yet borrows ¥several billion from banks at a high interest rate of 5%, this defies basic commercial logic (Why pay interest to borrow when you already have cash?). The conclusion is usually straightforward: that ¥10 billion is fake—it may be frozen or already misappropriated by major shareholders. This was precisely the hallmark pattern preceding Kangmei Pharmaceutical’s collapse. 2. Operating Assets: A Litmus Test for Business Model Strength These items reveal the company’s position within its industry chain. • Accounts Receivable (IOU)—Who Is Holding Whom Hostage? • Fundamental Analysis: Lower is better. The ideal scenario is a *negative* figure (reflected as advance payments received / contract liabilities), indicating customers prepay before delivery. • Risk: If revenue grows by 10% while accounts receivable surge by 50%, the company is likely forced to extend credit just to move inventory—meaning it has been held hostage by downstream customers. Its reported profits are little more than promissory notes. • Inventory—A Granary or a Landfill? • Red Flag Warning: For Moutai, inventory appreciates with age; for tech firms (obsolete chips) or apparel companies (out-of-season garments), unsold inventory—unless properly written down via “inventory write-down provisions”—is a landmine buried in financial statements. Once triggered, it can instantly obliterate current-period profits. • Goodwill—Emphasized “Air” • This intangible asset arises from acquisition premiums. If you pay ¥1 billion for a company worth only ¥200 million, the extra ¥800 million becomes goodwill. • Logic: Goodwill represents an “advance draw” against future profitability. Should the acquired company underperform, goodwill must be impaired. Companies with high goodwill appear mythical in bull markets—but often become jokes in bear markets.

Adapting Walter Schloss’s Value Investing Strategy to the Chinese Context—The EAD Framework

I. Origins: Schloss’s Orthodox Approach and a ‘Mismatch’ Problem Walter Schloss was one of Benjamin Graham’s purest disciples. His methodology was remarkably simple: buy cheap assets—low price-to-book (P/B) ratios, tangible assets trading at discounts, broad diversification, no earnings forecasts, and no meetings with management. Throughout his career, he essentially did just one thing: seek companies whose stock prices were far below their net asset liquidation values—and wait for intrinsic value to reassert itself. If we abstract Schloss’s original logic into a sequential screening process, it is fundamentally A → D driven: first verify the authenticity and solidity of assets (Assets), then assess whether the price (Discount) is sufficiently attractive. Earnings (E) carried relatively low weight in his framework, as he believed, “If you buy cheap enough, time will work for you.” Yet when transplanted to China’s A-share and Hong Kong markets, a sharp problem emerges: Cheapness does not guarantee you’ll actually capture that cheapness. In mature U.S. markets, undervalued assets ultimately deliver value back to shareholders—via mergers & acquisitions, liquidation, share buybacks, or dividends—thanks to robust takeover markets and strong shareholder rights protection. In contrast, across A/H-share markets, we repeatedly encounter companies holding enormous cash reserves, trading persistently at P/B ratios as low as 0.3, with solid underlying assets—yet refusing to pay dividends or conduct buybacks for over a decade, leaving their stock prices languishing. The assets are real. The cheapness is real. Yet shareholders never receive the value. This is what we call the “value trap.” It is precisely this core localization challenge that gave rise to the EAD framework—not as a modification of Schloss’s method, but as a China-specific variant designed expressly for local market realities. Prioritizing E (Earnings) is its innate, foundational principle. II. Why E Comes First: From an “Asset-Centric” to an “Realization-Centric” Mindset EAD follows the strict, non-reversible sequence: E → A → D. This reflects a layered, progressive filtering logic. E must come first because it answers two existential questions: 1. Earnings Quality (E1): Can this business sustainably generate profits? Schloss’s original framework adopts a static, asset-oriented perspective. In A/H-share markets, however, we supplement it with rigorous scrutiny of business models and competitive positioning: • Where does the core business sit in the industrial chain (upstream/midstream/downstream)? • Does it possess moats such as monopolies, licenses, or franchise rights? • What is its bargaining power vis-à-vis upstream suppliers and downstream customers (does it collect payments from others—or get squeezed by them)? • What are the levels and trends of gross and net profit margins? The rationale is simple: a company perpetually hemorrhaging cash sees its assets shrink continuously. The tangible net assets you calculate today may be eroded tomorrow by losses. Thus, before recalculating assets (A), you must first confirm the business remains viable—and capable of self-sustaining cash generation. This is why we set **Red Line #1 (immediate elimination for consecutive losses or persistently negative operating cash flow)**: if the business itself cannot survive, verifying asset authenticity becomes meaningless. 2. Distribution Willingness (E2): Will the company return earned profits to shareholders? This is the soul of the entire localization design—and the most critical, yet weakest, element in Schloss’s original framework, where it proves most fatal in A/H-share markets.

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Sasol Ltd shares trade near recent lows amid concerns over its leveraged balance sheet and volatile energy prices. The company prioritizes debt reduction and a strategic shift toward chemicals and lower-carbon solutions.

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