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.
https://myinvestingnotes.blogspot.com/2010/06/finding-great-companies-what-you-want.html
Main Points of the Article:
The Ideal Profile: Look for companies with a cash-rich, asset-light business model that demonstrate operational dominance, pricing power, and financial resilience—similar to Microsoft or Coca-Cola.
Balance Sheet Checklist:
Lots of Cash: Provides safety and funds growth without external help.
Low Flow Ratio (<1.25): The key metric. Indicates operational efficiency and supply chain power: low inventories/receivables and strategically high payables.
Manageable Debt: Debt is a tool, but prefer companies with more cash than long-term debt.
Income Statement Checklist:
High & Consistent Revenue Growth: Sign of strong demand (8-10%+ for large caps, 20-30%+ for small caps).
High & Stable Gross Margin (>40%): Indicates a "light" business with pricing power and a competitive moat.
Rising R&D Spending: An investment in future growth (especially for tech/pharma).
Full Tax Rate (~34%): A quality-of-earnings check. Be wary of profits boosted by temporary tax credits.
Strong & Rising Net Profit Margin (>7-10%): The result of a successful, defensible business model.
Cash Flow Statement Mandate:
Positive Operating Cash Flow: A non-negotiable sign of a self-sustaining business for public companies. Investigate any negatives deeply.
Critical Overarching Principles:
Context is Key: No rule is absolute. Metrics must be judged relative to industry norms and company life cycle.
The "Why" Matters: The story behind the number (e.g., why inventories are high) is more important than the number itself.
This is a Quality Filter, Not a Valuation Tool: The checklist identifies great businesses, but does not tell you if the stock is a good buy at its current price.
Article Summary:
This article provides a practical, fundamentals-based checklist for identifying high-quality companies with durable competitive advantages. It moves beyond simple profitability to focus on operational efficiency, financial strength, and strategic positioning.
The core philosophy seeks businesses that generate so much demand and possess such market power that they:
Sell inventory quickly.
Collect payments from customers upfront (low receivables).
Can delay payments to suppliers (high payables), using that cash as interest-free financing.
Fund all growth internally with abundant cash, avoiding excessive debt.
The guidelines emphasize looking for strengthening financial trends—rising margins, growing cash, and efficient use of capital. It stresses that while few companies are perfect, this framework helps investors ask the right questions, distinguish operational brilliance from financial distress, and ultimately find businesses built to thrive and generate real wealth over the long term.
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A detailed discussion
This is a highly practical guide to fundamental analysis, focused on identifying high-quality, well-managed companies with sustainable competitive advantages. It moves beyond simple profitability to assess operational efficiency, financial strength, and strategic positioning. Let's break down, discuss, and summarize the key points.
Core Philosophy: The "Ideal" Business Model
The article champions a specific, powerful business archetype: the cash-rich, asset-light operator with pricing power. Think Microsoft or Coca-Cola. These companies:
Generate products/services with high demand (high revenue growth).
Have low capital intensity (high gross margins).
Exercise such market strength that they get paid upfront by customers (low receivables) and can delay paying their suppliers (high, strategic payables), all while holding minimal inventory.
Use this operational dominance to fund growth internally (plentiful cash, minimal debt).
Summary & Commentary on Key Guidelines
1. Balance Sheet: The Fortress of Financial Health
Lots of Cash: The ultimate safety net. It provides optionality for investment, acquisitions, or weathering downturns without relying on external capital. Comment: While crucial, context matters (e.g., a mature tech giant vs. a fast-growing biotech startup). The key is why the cash is there and how it's being (or not being) deployed.
Low Flow Ratio (<1.25): This is the article's most nuanced and insightful metric. It measures operational efficiency and supply chain power.
Low Numerator (Non-cash Current Assets): Means the company isn't tying up cash in inventory (it sells quickly) or waiting on customers to pay (it collects quickly).
High Denominator (Non-debt Current Liabilities): Means the company is using its suppliers' money as interest-free financing—a sign of strength, not weakness, if done from a position of cash abundance.
Comment: This is a brilliant way to separate operational genius from financial distress. The caveat about small-caps is vital; they lack the clout of giants, so a higher ratio isn't automatically a red flag.
Manageable Debt: Debt is a tool, not a sin. The guideline wisely avoids a hard rule, favoring a preference for companies with "more cash than long-term debt." Comment: The debt-to-equity assessment must be industry-specific (utilities vs. software). The critical questions are: What is the debt for? Can operating earnings easily cover interest payments?
2. Income Statement: The Engine of Profitability
High Revenue Growth: The primary indicator of demand. The article sets good benchmarks: 8-10%+ for large caps, 20-30%+ for small caps. Comment: Sustainable growth is key. Growth from acquisitions or price hikes alone is less robust than organic, volume-driven growth.
Controlled Cost of Sales & High Gross Margin (>40%): This is the moat indicator. A high and stable/rising gross margin shows pricing power and an ability to scale efficiently. The "light business" bias is clear—intellectual property and software are favored over heavy manufacturing. Comment: Absolutely critical. A shrinking gross margin is often the first sign of competitive pressures.
Rising R&D: Framed as an investment in the future, especially for relevant sectors. Stagnant or falling R&D can signal a company is milking a legacy business at the expense of its future. Measuring it as a % of sales is smart.
Full Tax Rate (~34%): A clever quality-of-earnings check. Companies using loss carryforwards or other credits boost current earnings artificially. "Taxing" them at the full rate reveals the true, sustainable profit growth.
Strong & Rising Net Profit Margin (>7-10%): The bottom-line result of all the above. High margins in a capitalist system signal a successful defense against competition. As the article notes, some great businesses (e.g., high-volume retailers) operate on thin margins, but they are exceptions that prove the rule.
3. Cash Flow Statement: The Reality Check
Positive Operating Cash Flow: Non-negotiable for a mature public company. Earnings are an opinion; cash is a fact. Negative operating cash flow means the business isn't self-sustaining. Comment: This is the ultimate litmus test. You must investigate the reason for any negativity (e.g., a temporary inventory build for a hot product vs. soaring receivables because customers won't pay).
Critical Discussion Points & Caveats
The "Ideal" is Rare: The author admits few companies hit all marks. The checklist is a framework for excellence, not a pass/fail test. It helps you compare companies and ask the right questions.
Industry Context is Everything: Applying these rules rigidly across sectors is a mistake. Comparing the flow ratio of a software firm (low inventory, high payables) to a supermarket chain (high inventory, low payables) is meaningless. The guidelines work best for evaluating companies within their peer group.
The "Why" is More Important Than the "What": This is the article's most important lesson. A high flow ratio could be brilliant or disastrous. Spiking inventory could be mismanagement or preparation for a blockbuster launch. Your job as an investor is to discover the narrative behind the numbers.
No Valuation Consideration: The article explicitly stops at quality identification. A great company can be a terrible investment if you pay too much. The next critical step is to determine if the company's stellar characteristics are already reflected in an inflated stock price, or if there's an opportunity to buy a wonderful business at a fair price.
Quality of Earnings: The guidelines subtly emphasize this throughout (tax rate, cash flow vs. net income, receivables). They push you to ask: "How sustainable, real, and repeatable are these profits?"
Final Summary: The Investor's Checklist
You are looking for a company that demonstrates:
Operational Dominance: Low Flow Ratio. It controls its working capital cycle like a master, collecting fast and paying slow because it can.
Financial Fortress: Ample cash, minimal (or smartly used) debt. It is self-funding and low-risk.
Profitable Growth: Strong, consistent revenue growth combined with high and expanding margins (both gross and net). It sells more while keeping more of each dollar.
Real Cash Generation: Consistently positive cash flow from operations. The profits are genuine and liquid.
Future Focus: Willingness to reinvest in the business (R&D) to maintain its competitive edge.
Clean Accounting: Pays close to the full corporate tax rate, suggesting earnings are not being boosted by non-recurring credits.
In essence, you are seeking a business that is not just profitable, but efficiently, powerfully, and sustainably profitable, with a model that throws off excess cash and fortifies itself against competition and hardship. This framework provides a powerful lens to separate truly exceptional businesses from merely adequate ones.
