Source: http://asianbeacon.org/

Check the Finances

Having understood the company and its business, we will now check for its health state, in particular the financial health. If you dig out an annual report now, you will be overwhelmed by the amount of financial numbers in it. If you ask a thousand investors which number is the key to analysing the financial health, you will probably get a thousand different answers. There are many ways to skin the cat, but I’ve arrived at a method based on 4 financial numbers.

I understand some of us may be uncomfortable with only 4 financial numbers. However, we only have 24 hours a day, and there are so many things to be done. We need to be highly selective and ask for the best return on our time. Imagine the scenario, if you were told that you could either (1) work 100 hours for $100 profit or (2) work 20 hours for $30 profit. Which would you choose? I will choose (2) all the time because your per hour rate is higher! (1) $1/hr (2)$1.5/hr.

Therefore, I have chosen these 4 financial numbers which form the key attributes of a company in good financial health. Now let’s go through how and why each financial number is important

Source: http://ej4.com/

#1 Shareholder Friendly Practices

First we need to identify companies which are shareholder friendly, meaning they act in the best interest of the shareholder and not squander your money away!

Companies can use their earnings in many different ways. They can reinvest into their business, pay back their debt, pay dividend to the shareholders or even expand their business. Depending on their choice, it will have different impact on the stock prices in the future. Without going into too much details of each choice, it is safe to say that we should focus on companies that does either one, if not all, of the following shareholder friendly practices:

1. Return cash to shareholders through dividend
2. Reduce their debt by paying back with cash
3. Repurchase shares from the market with cash

If a company is actively carrying out these shareholder friendly practices, it means they are financially healthy. In order to generate enough cash to pay dividend, reduce debt and repurchase shares, the company must be operating an efficient business with a substantial profit.

The simplest way to identify these shareholder friendly practices is to look for highly negative financing cashflow in the Cashflow Statement. A negative financing cashflow means cash is leaving the company to pay for debt, dividend or repurchase shares.

#2 Strong Returns on Investment

When we buy a stock, we are investing in the company business, and we want the highest return possible for every dollar invested. Similarly, a company also seeks the highest return possible for their investment. The main difference is while we invest in stock, companies invest in other assets such as equipment, marketing, property, people, etc.

We can measure their ability to do so by looking at their return on invested capital (ROIC). This is different from the other commonly used indicators such as return on equity and return on asset. ROIC is simply the operating income divided by the invested capital (There is a very good article by Damodaran on it).

While this requires our own calculation, it is by far the best indicator in my opinion as it shows us exactly how the company is using its invested capital. A high ROIC means the company is really getting the best bang for its buck.

#3 Quality Earnings (Strong Cashflow)

If you ever pay any attention to the news, you would have most likely heard news like this: “Company XYZ’s reported earnings missed expectations by 2 cents, stock fall 5%”. Indeed most of the world and investors focus a lot on the reported earnings of companies every quarter, and rightfully so because earnings create cash and cash keeps the world goes round.

However, not that many focus on the quality of earnings. The reason is that earnings can be “falsified”. It may be a strong word but it’s true. I will use a simple example to illustrate it.

Let’s assume we have 2 candy stalls, Sweetie and Toothache. Both stalls sell 100 candies at $1 each today. Sweetie sold all 100 candies and received $100 in cash; while Toothache sold all 100 candies and only received $80 in cash because a boy bought 20 candies on credit. If both were to report earnings the next day, Sweetie will report $100 earnings and $100 of cashflow but Toothache will report similarly $100 earnings and $80 of cashflow. While the example is simplified, it has shown that both stalls can report the same earnings despite the difference in actual cash received.

Therefore, instead of paying too much attention on earnings, we should focus on cashflow because it is much harder to manipulate and a much better way of evaluating a company’s earnings. A quick way to determine the quality of earnings is to divide the operating cashflow over the reported earnings. The higher the number the better because that means the company’s earnings is strongly backed by actual cash.

Source: http://howng.com/

#4 Reasonable Debt

Finally, the much dreaded debt. While almost all companies operate with some level of debt, we want to make sure that the company is not overladen with debt. The main problem with debt is not debt itself but the interest that it carries. If the debt has no or very low interest, it is a good debt! This is why banks are more than happy to take on debt when you deposit cash into your savings account; the interest rate is miniscule.

However, most debt comes with a significant interest rate, and that’s why you should select companies with a reasonable level of debt.

The quick way to determine the level of debt is the ratio of debt to equity (D/E). It tells us whether the company is able to pay off their debt. We would prefer a company with a D/E ratio of less than 0.8. If it is more than 1, it means the company will not be able to pay off its debt even if it liquidates all its assets, and that’s not very assuring.

If you assess a company based on these 4 financial figures, you are likely to find companies with very good financial health.

Next week, we will discuss about the final step of finding its value and when to buy a stock. Stay tuned!

See you soon!

Investing Always,

Pete

Please refer to the disclaimer here