Analyse a company’s financials — without being an accountant

NAV TL;DR

If you don’t have time to read through the whole article, you can check out our short version below:

Here’s a 7-item checklist to analyse a company’s financials and determine if it is investment-worthy:

• Consistent revenue growth.
• Consistent earnings growth for the last three to five years or more.
• Relatively high net profit margins compared to its peers in its industry. The higher the profit margin, the more profitable and cost-efficient a company is.
• Generate positive operating cash flow (OCF) and have a history of consistent OCF growth that grows in tandem with its revenue and profit.
• High, consistent current ratio, which measures a company's ability to pay its short-term liabilities with its short-term assets.
• Low debt/equity ratio. The higher the ratio, the more aggressive a company is in financing its business operations using debt.
• High, consistent return on equity.

Perhaps you’re ready to start buying stocks. But how do you determine if a company is as good as people say?

We highlight 7 factors to watch for:

Consistent growth in revenue

Revenue is basically the amount of money a company receives for selling their products/services. In accounting terms, it is sometimes referred to as “sales”.

For example, Company X sells 10,000 widgets at a hundred dollars each in one year, the company’s revenue for that year is:

You want to look for:
A company that has a history of consistent revenue growth for the last three to five years or more. Quite simply, you want to invest in a company that is able to grow and make more money with time.

Consistent growth in net profit

Net profit (or net income or earnings) is the amount of money a company retains after deducting total expenses and taxes from its revenue.

Continuing on from our earlier example, if Company X makes $1 million in revenue and has total expenses and taxes of $750,000 for the year, its net profit would be:

Net profit is hugely important because a company might have large growing revenues, but still be unprofitable. This can happen if its costs are rising faster than its revenues, and hence its profit margins are shrinking.

You want to look for:
A company that has a history of consistent earnings growth for the last three to five years or more. A company that has growing revenues and stable profit margins should have its net profit growing in tandem as well.

High, consistent net profit margin

Net profit margin measures how much out of every dollar of revenue it keeps as profit.

Using the same example, if Company X’s revenue is $1 million and a net profit of $250,000, its net profit margin would be:

You want to look for:
A company with high net profit margins compared to its peers in its industry. The higher the profit margin, the more profitable and cost-efficient a company is.

Positive operating cash flow (OCF)

OCF is the amount of cash generated by a company’s normal business operations. Cash flow is extremely important because it indicates whether a company is able to generate enough cash to stay in business.

Let’s go back to our example: Company X has revenues of $1 million and total expenses and taxes of $750,000 in a year.

But if it can only collect $600,000 in payment for the widgets it sold, it means its business operations don’t generate enough cash to cover its total expenses; it would have a negative cash flow of $150,000.

In this case, if Company X doesn’t have enough cash reserves or can’t borrow the money to cover its total business expenses, it will go bankrupt!

You want to look for:
A company that generates positive operating cash flow and has a history of consistent OCF growth that grows in tandem with its revenue and profit.

High, consistent current ratio

Current ratio measures a company’s ability to pay its short-term liabilities with its short-term assets. The higher the ratio, the more capable the company is of fulfilling this.

A current ratio less than 1 means that a company might have difficulty paying its short-term liabilities when they become due, which is not a sign of good financial health.

You want to make comparisons:
It is also useful to compare a company’s current ratio with peers in the same industry to try to understand if the company’s current ratio is typical of its industry.

Low debit/equity ratio

Debt/equity ratio compares a company’s total liabilities to its total shareholder equity. The higher the ratio, the more aggressive a company is in financing its business operations using debt.

Most people always put their guard up the moment debt is mentioned. But in business, debt is fairly common. The only thing you must ensure is that the debt is manageable.

Debt can increase shareholders’ returns as the company uses it to finance bigger business operations to potentially generate more revenue and profit.

However, the increase in earnings must outweigh the cost of the debt’s interest payments. It can become risky if a company borrows too much debt and its business operations don’t go as planned and profits take a hit. This can sometimes lead to bankruptcy.

Understandably, the lower the debt, the easier it can be managed and the less risk a company carries. The higher the debt, the more risk a company has.

In general, you would want to be a little wary if a company has a debt/equity ratio of more than 1.5 and you might want to ask some hard questions of a company with a ratio of 2 or above.

You want to make comparisons:
However, compare this with a company’s peers in the industry to get a clearer picture of what is acceptable or good. For example, capital-intensive industries tend to have higher ratios, while a service-base industry might have lower ratios.

High, consistent Return On Equity (ROE)

ROE measures how much profit a company generates with the money shareholders have invested. The higher the ratio, the better the company is at generating profit on its shareholders’ funds.

ROE is one of the more important ratios you should pay attention to. Your chance of making money on a stock over the long-term should be higher with companies that consistently generate high ROEs.

You want to make comparisons:
The average ROE for Singapore companies is around 10%, but there are wide differences between the industries, with manufacturing registering some of the highest ROEs, and transport and storage some of the lowest. So, it is important to consider each company’s ROE relative to its industry peers.

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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.

All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.

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