Bank failure Friday + teachable moment for investors

May 22, 2010

Just one small bank shuttered tonight.

#73

–Failed bank: Pinehurst Bank, St. Paul MN
–Acquiring bank: Coulee Bank, La Crosse WI
–Vitals: assets of $61.2 million, deposits of $58.3 million
–Estimated DIF damage: $6.0 million

As a reminder, FDIC still has $63 billion of cash on the balance sheet despite the fact that it showed a negative balance of $20.7 million at the end of Q1.

How’s that? Assets = Liabilities + Equity.

Cash assessments collected from banks are assets on the left side of the balance sheet, but how they’re accounted for on the right side can be complex. Normally FDIC counts these as its own capital, as equity, also called the DIF’s “balance.” But because these were regular assessments collected up front, they’re counted as deferred revenue — a liability — instead of as equity.

So FDIC has more than enough cash raised from banks to pay for bank failures on its radar. The issue is banks that aren’t on its radar, i.e. the TBTFers. Those guys have raised a fair amount of capital, but if any one goes down, it would quickly overwhelm the DIF, forcing FDIC to borrow from Treasury.

TEACHABLE MOMENT…

For those that don’t understand deferred revenue, it’s a simple accounting idea that’s important to master because it’s the key to finding the best investments, the kind that made Warren Buffett rich.

In a nutshell, deferred revenue is revenue that’s been received, but not yet earned. For example, a newspaper business might charge for a yearly subscription up front, but it has to deliver the product over the following 12 months.

The idea behind your basic income statement is to match revenue with expenses incurred to generate it. So if I get paid up front to deliver 12 months worth of newspapers, then I recognize the revenue over 12 months even though I got all the cash on day 1.

On the asset side of the balance sheet, cash is cash. But on the right side, instead of as equity, it’s counted as deferred revenue, a liability I have to work down by delivering my product over the specified period of the contract with my customer.

So why is having lots of deferred revenue the characteristic of a good business? It reduces risk. Wouldn’t you rather get paid up front to deliver a product or service than to put all the work in first? For instance, retailers have to invest in inventory to stock their shelves for the Xmas season. But maybe the retailer screws up, stocking his shelves with tickle-me-Elmos and slap bracelets when kids today are looking for a Blu-Ray PS3 or the latest Justin Bieber album. Retailers can quickly go out of business this way, investing in inventory that doesn’t sell.

There’s also the problem of receivables collection. Powerful customers can demand I deliver my product today, and then not pay me for 30 to 90 days. Sometimes, they may not pay me at all and I have to write off what they owe me as uncollectable.

These risks are removed if the equation is flipped and I get paid before I deliver my product.

Warren Buffett’s path to riches was paved by the ultimate deferred revenue business: insurance. He gets paid premiums up front and only incurs expenses as claims are filed. In the meantime, he gets to hold on to the premiums (called “the float”), which he can invest in the stock market. And if no claims are filed, then he gets to keep the cash collected. Pretty cool.

So, when looking to invest, always pay attention to how cash flows into and out of a business.

In particular, calculate “capital employed” on the balance sheet. There are a few different ways to do it, but the way I was taught:

Capital employed = (receivables + inventories + prepaid assets + net fixed assets) – (accounts payable + accrued expenses + deferred revenue)

If this figure is consistently negative over time, it’s a sign of a good business.

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