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

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:

1. 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.

2. 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.

3. 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.

4. Cash Flow Statement Mandate:

   • Positive Operating Cash Flow: A non-negotiable sign of a self-sustaining business for public companies. Investigate any negatives deeply.

5. 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.

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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

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

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.

Summary

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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https://myinvestingnotes.blogspot.com/2025/12/finding-great-companies-what-you-want.html