Investing in the right business through the stock market can bring substantial financial benefits. Savvy investors know that putting money to work is a clever approach which has been used for centuries. However, the key to success is to protect our investments. As Warren Buffet says, the two most important rules are: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
In this article, I want to present my top 10 things to look for before buying a business. They have the role to help us with finding major flows in a company or to indicate that a business might be a good opportunity for an investment. Analyzing a company is a kind of detective work. Like Hercule Poirot, we try to find indices and determine the true financial situation of a business. If we find and analyze enough indices, we might decide that we have sufficient information about the business to buy it.
Before we look at these 10 things, I would like to stress one important fact that considerably improved my investing. Buying shares means buying part of a company, not transferring your money to a broker and hoping that this bet will end up well. Imagine that you are going to be the owner of Apple, Pfizer or any other company, although you might own just 0,00001% of it. This mindset is a big help because it urges us to analyze the company before buying it. It also helps us to gain confidence, so that we do not need to follow the stock chart and its price on a daily basis.
Income statement, balance sheet and cash flow statement – the major “pieces of evidence”
There are three key sources of information about a company, three “major pieces of evidence”. These are its income statement, balance sheet and cash flow statement. These documents will tell us a story about the company. The more we know how to read them, the better we understand the business. We will divide our 10 things to look for in three categories, in accordance with the above-mentioned documents + one extra category.
If a company fails to pass one of the following criteria, it does not mean that it is a bad company. It means that we better explore the particular area in more detail. If there is no time or willingness to explore this from our side, it might be a reason to look for another company to invest in.
By the way, we are not going to focus on price/earnings ratio or book value of a business, which can be easily found on many websites. We will go a little bit deeper to collect more information. Equally, we will look at things differently, in a more professional way.
This might seem like a little bit advanced stuff, but do not worry. I will try to explain it in a way that makes it understandable for everyone. There will be some calculations, but all fairly easy.
Where savvy investors search for data?
All the presented financial data are publicly available on the internet. I usually use investing.com for the first glance as it provides quick access to income statement, balance sheet and cash flow statement. Occasionally though, I find incorrect figures there. Hence, it is always good to look at the financial reports when seriously thinking about an investment. Financial reports can be easily found e.g. on EDGAR or on the company’s website.
Income statement of a business
The income statement shows us what is the revenue of a company (income from selling goods or services), what are the costs and what is the ultimate profit.
In general, it is advisable to buy companies that can generate at least some profit after taxes. Ideally, the profit should grow over time. This is the case for many companies, so which one to choose? We need to look at other things.
1. Are earnings before interest and taxes more than 3x higher than the interest expense?
The first thing that I look for in the income statement is whether earnings before interest and taxes (EBIT) are substantially higher (at least 3 times as an absolute minimum) than the interest expenses that a company needs to pay. In other words, whether the company earns enough money to be able to pay the interest on its debt and have additional money for other purposes.
2. Is there any extensive cutting of costs?
The second important thing that I look for are costs of goods sold and operating costs. It is important to know whether the company tries to cut its costs. As a matter of fact, costs are not a bad thing. Only extensive costs are worth cutting. If a company wants to have high-skilled employees or use high-quality materials, these all come with costs. Usually, a company begins to cut costs when it experiences some kind of problems, e.g. preparing for financial trouble. Hence, if the revenues stay the same and the profit increases just because of cost cutting, it should set off alarm bells. If we want to purchase this company, we need to explore this in detail. For example: Has the company started to reduce the number of employees or were they able to reach a higher-scale operation?
3. Is the net margin growing or is it higher than by competitors?
Margin is very important as it basically reflects how profitable a company is. To be concise, let’s just look at the net margin. The calculation is very simple in order to get the net margin. We just need to divide profit after tax by revenue. The result shows us how much the company makes from $100 in sales. The best way to know whether the company, in which we want to invest, has a good profitability, is to compare it with other competitors. This is because margins vary considerably from one industry to another. While for retailers, it can be normal to have a net profit of $3 per $100 in sales (net margin of 3%), a technology or pharmaceutical company can easily have net margin of 30%.
In a balance sheet, you will find what a company owns and what it owes. There we can see how much cash or inventories a company has, whether it owns some properties, equipment or some intangible assets. The second part of the balance sheet shows the company’s liabilities. Whether it has debt and how much of it or whether it was able to require its assets through its own money, i.e. equity. The balance sheet distinguishes between current assets/liabilities and long term ones. Current assets can be liquidated faster, in case there is a sudden need for cash. Accordingly, current liabilities are those which needs to be paid in the following 12 months.
4. Too high amount of current assets are not always good
To continue with our top 10 things, we need to look at the company’s current assets. It is true that every company needs them because they provide much needed liquidity. It is also important for a company to have more current assets than current liabilities to have working capital. However, current assets are not necessarily put into use to efficiently generate new cash.
Let’s look at the following example. Imagine, “airline A” and “airline B” both have sufficient cash and airline A decides to buy new airplanes (long term assets) which generate new money for the company, while airline B continues to sit on the excessive cash. In this case, airline A might be a better investment. Cash lays in a bank, receivables is money on the way to the company and inventories sit in a store house. If a company has a too high amount of current assets, this might be a sign of inefficiency of its management. One needs to be particularly careful when inventories and receivables are increasing year over year when the revenue stays the same.
5. Large funding gap
To know, how large a financing gap of a company is, we need to look at its receivables, inventories and payable. There is a simple mathematical formula for this. The formula shows us in how many days the company can sell its inventories, how long it takes until the company receives cash from its customers and in how many days the company must pay to its suppliers. The lower the number of a funding gap, the better.
If a company can sell its inventories fast, it does not receive money from its customers too late and at the same time it has been able to negotiate longer time period to pay its suppliers, the business will not have a very large funding gap. This is a sign of good management. In the opposite case, the company would likely need to borrow money to finance a large gap. The reason is the need for financial resources in the time period until the business receives money for sold goods and after it paid its suppliers.
6. Return on assets
When looking on return on assets, we try to determine how efficiently the company puts its assets into use. The assets – machines, airplanes, production facilities – have to work for a company to generate revenue and subsequently profit. If you divide yearly revenue by total assets and the result will be more than 1, this would be an excellent return.
This calculation shows the return a company has on its assets and we want revenues to be at least as high as the company’s total assets. If assets stand still or are not utilized properly, this does not help the business to grow.
7. Too much debt in relations to assets
If everything what a company owns is based on debt, this also sets off alarm bells. It is always good when a company has its own capital in form of equity. This might be what the owners paid in the company or what the company collected as retained earnings from previous years.
It is difficult to write a concrete figure which exact ratio of debt to equity is the best because it depends on many variables. For example, a company might be willing to take more debt when the interest rates are low. A utility company might take more debt because in this kind of business, the profits are more predictable. Always compare the situation of that particular company with its competitors in the same business field.
Sustainable Growth Rate (SGR)
In addition, one useful tool is to determine the sustainable growth rate (SGR) of a company.
Here comes another simple calculation. First we divide the company’s profit after tax from this year by the equity of the company from previous year. The result is called return on equity (RoE). The next step is to look at how large part of the profit stays in the company because it has not been paid out in form of dividends. This will show us the retained rate. If we multiply these two results, we will see the sustainable growth rate. It shows us what the maximal percentage of growth for a company is, if using just its own money. Any higher growth would have to be based on debt.
Cash flow statement
In simple words, cash flow statement reveals where the cash comes from and what it is used for. In a cash flow statement, you will see 3 different categories:
a) Cash from operating activities: Cash that the company generates from its core business. In case of airlines, it would be from transporting passengers.
b) Cash from investing activities: This category list, on one hand, outgoing cash flow used to purchase new assets, such as property, equipment etc. On the other hand, it is the cash that the company received from selling properties or parts of their business.
c) Cash from financing activities: Cash that the company received by borrowing money etc. or cash that was used to pay dividend, repay debt or purchase own shares.
8. Cash from operating activities should be higher than the company’s profit for the same period
To determine a profit of a company in the income statement, we deduct from the profit several items such as deprecation* or amortization. This is money which, in reality, does not leave the company. Therefore, the company should have more cash than stated. In other words, the cash from operating activities should be higher than the profit. This will occur in the majority of companies. If this is not the case, the company is losing/putting cash somewhere, which needs to be closely looked at.
[*Deprecation is an accounting trick to correctly assess the finances of a company. Best is to explain through an example. When buying a washing machine and paying the price immediately, the amount that we paid will be divided, let’s say, into 5 pieces. 1/5 will be deducted from our profit every year for the next 5 years. When looking at the third year, 1/5 of the price of the washing machine will be deducted from the profit, but the cash is not really leaving the company because we have already paid for that washing machine.]
9. How does the company finance its dividend?
An easy method to determine whether a company operates in a sustainable way is to look at how it finances its dividend.
There might be a nice amount of money generated by the core business, but the company might also need to invest in equipment to secure its future. These capital expenses might take all the cash from operating activities. Despite that, the company does not want to break its dividend policy and decides to pay its dividend. To be able to do this, it needs to borrow money from a bank. This might happen in one quarter, but not regularly. Otherwise, you might want to re-think your investment in this company.
This is something different that the dividend pay-out ratio which shows which portion of profit was paid as dividend. Cash flow statement provides you with more detailed information. If we see that the cash from operating activities is not enough to pay the dividend and the dividend is paid from an additional loan, then this is another warning sign.
10. Does the company rely on a major customer or a major supplier?
It makes a company vulnerable, if it relies just on one major customer who buys the majority of its products. The company might be extremely profitable, but if a major customer changes its mind, it creates a serious issue. There was a case in Germany, when Volkswagen cancelled contracts with several manufacturers of parts for their cars. The manufacturers did not have any customer other than Volkswagen. This dependency created an existential problem although they operated absolutely flawlessly. Similarly, if we want to invest in a retailer selling shoes, but 80% of all sold shoes comes from Nike, we might want to be a little bit careful. What if Nike finds a better way to channel their shoes to the final customer?
Long-term investing in shares can improve our financial situation. There are thousands of interesting companies to invest in. Sometimes, it might be a challenge to find the right one where to put our money. Once we finally see an interesting company as a potential investment, there is much more to discover than just e.g. low price/earnings (P/E) ratio or other quick methods to determine whether a company is undervalued. We need to put the business through a test to see how well it is managed. This article strives to present my top 10 things to test a company on.
In my approach, I try to eliminate what might go wrong. There are many areas to look at within a business. With every check, we are one step closer to say that this part of a company or this aspect of a business looks healthy. Once I eliminate enough potential problems and I see that the company passed enough tests, I feel confident to choose it as my investment.
The end is just the beginning
With this article, I would like to start a new series on Premium-Flow. I will take two companies (they might be competitors) and I will submit them to the test, finding out all the above-mentioned attributes. This way, I would like to create value for my readers, potential fellow investors. Hence, if you have the first two candidates in mind, please let me know.
I am sure investors will use different approaches. My list is not exhaustive, but it can provide much better understanding of a company. I hope that you find it useful. What are your top 10 things to look at? Write me in the comments below.