Monday, 21 June 2010

Finding great companies: What you want to see on their financial statements?

If you're committed to finding great companies and investing in them, it is time to state clearly what you should actively seek out on financial statements.  Here now is what you should hope to find when you're studying the report of a company that you're considering for investment.  

What you want to see on a balance sheet?

1.  Lots of Cash

  • Cash-rich companies don't have trouble funding growth, paying down debts, and doing whatever they need to build the business.  
  • Increasing cash and equivalents is good.

2.  A low Flow Ratio

Flow ratio
=  (Current assets - Cash) / (Current Liabilities - Short term Debt)
=  Noncash Current Assets / Noncash Current Liabilities

Ideally, a company's flow ratio is low.  Once cash is removed from current assets, we are dealing almost exclusively with accounts receivable and inventories.  In the very best businesses, these items are held in check.  Inventories should never run high, because they should be constantly rolling out the door.  Receivables should be kept as low as possible, because the company should require up-front payments for its products and services.

So we certainly want the numerator of the equation (current assets minus cash) to be held low.

What about the denominator (current liabilities minus short-term debt)?  Rising payables indicate one of two things:

  • either the company cannot meet its short-term bills and is headed for bankruptcy, or 
  • the company is so strong that its suppliers are willing to give it time before requiring payment.  
You can be sure that companies in the latter category use their advantageous position to hand on to every dollar they can.   Again, think of every unpaid bill as a short-term, low-interest or interest-free loan.  If a company has plenty of cash to pay down current liabilities but doesn't, it is probably managing its money very well.  Those are the companies that we are looking for.

Ideally, we like to see this flow ratio sit low.  The very best companies have:  (1) Plenty of cash  (2)  Noncash current assets dropping (inventories and receivables are kept low) and (3)  Rising current liabilities (unpaid bills for which cash is in hand).

You'll prefer the flow to be below 1.25, which would indicate that the company is aggressively managing its cash flows.

Inventories are down, receivables are down, and payables are up.  This is a perfect mix when a company has loads of cash and no long-term debt.  Why?  Because it indicates that while the company could (1) afford to pay bills today and (2) doesn't have to worry about rising receivables, they are in enough of a position of power to hold off their payments and collect all dues up front.

When the flow ratio is high, another red light whirs on the balance sheet.

It must be noted here, however, that larger companies generally have lower flow ratios due to their ability to negotiate from strength.  Thus, don't penalize your favorite dynamically growing small-cap too much for a higher flow ratio.

3.  Manageable debt and a reasonable debt-to-equity ratio

Investors have very different attitudes toward debt.  Some shun it, choosing to not invest in companies with any or much debt.  This is fine and can result in highly satisfactory investment performance results.  But debt shouldn't be viewed as completely evil.  Used properly and in moderation, it can help a company achieve greater results than if no debt is taken on.

Debt can be good for companies too.  Imagine a firm that has a reliable stream of earnings.  Let's say that it raises $100 million by issuing some corporate bonds that pay 8 percent interest.  If the company knows that it earns about 12 percent on the money it invests in its business, then the arrangement should be a very lucrative one.

Note, though, that the more debt you take on, the greater your interest expense will be.  And this can eat into your profit margins.  At a certain point, a company can have too much debt for its own good.  Another feature of debt (or 'leverage') is that it magnifies gains and losses (just as buying stock on margin means that your gains or losses will be magnified).  Debt, like anything, is best taken in moderation.

To finance their operations, companies need sources of capital.  Some companies can survive and grow simply on the earnings they generate.  Others issue bonds, borrow from banks, issue stock, or sell a chunk of the company to a few significant investors.  The combined ways that a company finances its operations is called its "capital structure."  If you take the time to evaluate a company's debt, it could be worth your while.  Properly managed debt can enhance a company's value.

When you calculate debt-to-equity ratios for your companies, remember that there really isn't a right or wrong number.  You just want to make sure that the company has some assets on which to leverage its debt.  To that end, look for low numbers, ideally.  A debt-to-equity ratio of 0.05 isn't necessarily better than one of 0.15, but 0.65 is probably more appealing than 1.15.  You should also evaluate the quality of the debt and what it's being used for.  If you see debt levels spiking upward, make sure you research why.  Certainly, long-term debt can be used intelligently.  But in our experience, the companies in the very strongest position are those that don't need to borrow to fund the development of their business.  We prefer those companies with a great deal more cash than long-term debt.

Are any of our balance sheet guidelines hard-and-fast rules?  No.

We can imagine reasonable explanations for each.

  • A company can run inventories very high relative to sales in a quarter, as they prepare for the big Christmas rush, for example.  So, inventories may be seasonally inflated (or deflated) in anticipation of great oncoming demand.
  • And accounts receivable may be a tad high simply by virtue of when a company closed out its quarter.  Perhaps, the very next day, 75 percent of those receivables will arrive by wire transfer.  Here, the calendar timing of its quarterly announcement hurt your company.
  • Rising payables can also be a very bad thing.  If the company is avoiding short-term bills because it can't afford to pay them, look out!
  • Finally, flow ratios can run high for all the reasons listed above.

Having qualified our assertions, we still believe that the best businesses
  • have such high ongoing demand that inventories race out the door, 
  • product distributors pay for the merchandise upfront, 
  • the company has enough cash to pay off payables immediately but doesn't, and 
  • future growth hasn't been compromised by present borrowing.  

Look to companies like Coca-Cola and Microsoft to find these qualities fully realised.

What you want to see on the income statement?

1.  High Revenue Growth

You will want to see substantial and consistent top-line growth , indicating that the planet wants more and more of what your company has to offer.  Annual revenue growth in excess of 8 - 10 percent per year for companies with more than $5 billion in yearly sales is ideal.  Smaller companies ought be growing sales by 20 - 30 percent or more annually.

2.  Cost of Sales under wraps

The Cost of sales (goods) figure should be growing no faster than the Revenue line.  Ideally, your company will be meeting increasing demand by supplying products at the same cost as before.  In fact, best of all, if your company can cut the cost of goods sold during periods of rapid growth.  It indicates that the business can get its materials or provide its services cheaper in higher volume.  Where cost of goods sold rose outpacing sales growth, a red light just blinked from the income statement.

3.  Gross margin above 40%

We prefer to invest in companies with extraordinarily high gross margin - again, calculated by (a) subtracting cost of goods sold (cost of sales) from total sales, to get gross profit, then (b) dividing gross profit by total sales.

A gross margin above 40% indicates that there is only moderate material expense to the business.  It is a "light" business.  We like that.

Not all businesses are this light, of course.  Many manufacturing companies have a hard time hitting this target, as do many retailers.  Does that mean you should never invest in them?  No.  Does it mean you should have a slight bias against them in favour of higher-margin companies, all other things being equal?  Yes.

4.  Research and Development costs on the rise

Yes, we actually want our companies to spend more and more on research every year, particularly those in high technology and pharmaceuticals.  This is the biggest investment in the future that a company can make.  And the main reason businesses spend less on R&D one year than the last is that they need the money elsewhere.  Not a desirable situation to be in.  Look for R&D costs rising.  Of course, though, not all companies spend much on R&D.  A kiss is still a kiss, a Coke is still a Coke.

Generally, the best way to go about measuring R&D is as a percentage of sales.  You just divided R&D by revenue.  You want to see this figure trend upward, or at least hold steady.

5.  A 34% plus tax rate

Make sure that the business is paying the full rate to the government (Uncle Sam).  Due to previous earnings losses, some companies can carry forward up to a few years of tax credits.  While this is a wonderful thing for them, it can cause a misrepresentation of the true bottom-line growth.  If companies are paying less than 34% per year in taxes, you should tax their income at that rate, to see through to the real growth.

6.  Net profit margin above 7% and rising.

How much money is your company making for every dollar of sales?  The profit margin - net income dividend by sales - tells you what real merit there is to the business.

We prefer businesses with more than $5 billion in sales to run a profit margin above 7 percent, and those with less than $5 billion to sport a profit margin of above 10 percent.  Why go through all the work of running a business if out of it you can't derive substantial profits for your shareholders?

Another way of thinking about this is that in a capitalistic world, high margins - highly profitable businesses - lure competition.  Others will move in and attempt to undercut a company's prices.  So companies that can post high margins are winning; competition is failing to undercut them.  As with gross profits above, some industries do not lend themselves to a high profit margin.   For example, a certain company is unlikely to ever show high profits, but it remains a wonderful company.

What you want to see on the cash flow statement?

Net cash provided by (used in) operating activities is positive or negative.

If a company is cash flow negative, it means that these guys are burning capital to keep their business going.  This is excusable over short periods of time, but by the time companies make it into the public marketplace, they should be generating profits off their business.

If a company you are studying is cash flow negative, it's critical that you know why that's occurring.
  • Perhaps it has to ramp up  inventories for the quarter, or had a short, not-to-be-repeated struggle with receivables.  
  • Some companies are best off burning capital for a short-term period, while they ramp up for huge business success in the future.  
  • But if the only reason you can find is that their business isn't successful and doesn't look to be gaining momentum, you should steer clear of that investment.


You now have a fine checklist of things to look for (and hope for) on the balance sheet, income statement, and statement of cash flows.  Few companies are ideal enough to conform to our every wish.

The best businesses show financial statements strengthening from one quarter to the next.

For smaller companies with great promise and for larger companies hitting a single bad bump in the road, shortcomings in the financial statements can be explained away for a brief period.

But when you do accept these explanations, be sure you're getting the facts.  You want to thoroughly understand why there has been a slipup and do your best to assess whether or not it's quickly remediable.

We have, up to until now,  merely outlined the ideal characteristics, without ever putting a price tag on them.  Make sure you've mastered these basic concepts before fishing for some companies.

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