Take a look at a hand full of metrics relating to this companies financial statements over the last 10 year. In the search for a durable company with a strong financial advantage, we chart some metrics mentioned in the book Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage. The purpose of this blog is to introduce readers to some of the ways to interpret financial statements.
Please bear in mind that this is not financial advice and you should not base your trading/investing activity off of it, Always do your own research before investing.
Gross Profit Margin
"companies that have excellent long-term economics working in their favour tend to have consistently higher gross profit margins than those that don't" - Mary, Buffett. When a company obtains a market advantage it is also able to price products or services well above its operating expenses. So even though this is a simple metric, it can often be a good initial indicator of a company that has established itself, and enjoys a competitive or economic advantage above its competitors. So it goes without saying that the higher the gross profit margin the better, but also we should be looking for consistency and a long term trend.
Sales, General & Administrative
Again when it comes to trying to find a company with durability, consistency is something we like to see. Companies that have volatile SGA which fluctuate a lot tend to be companies suffering from intense competition. Also if SGA costs are high, that means this company is eating away at its gross profits at a greater rate. Generally speaking, the lower the SGA costs the better, and the less volatile the better still.
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Depreciation to Profit
As machinery and buildings wear out over their expected life span, this depreciation is recorded on the financial statements. After the initial outlay of the original asset, its loss in value will be calculated by the company using various methods and added back into earnings. Once the original cost of the asset is paid for, the company in question can continue to offset depreciation against earnings and add the depreciation back into earnings as a result. This leaves the company reporting a loss that isn't costing them any money (as the original outlay has been paid). However, eventually this company will need to replace said asset, and so depreciation should be seen as a real cost (seen in a way that illustrates how quickly its assets are subject to wear).
In this chart we look at how much deprecation the company has in relation to profits. Things to look for: because of the way depreciation is regarded, it may allow this company to borrow more. However once the asset needs to be replaced, they may struggle to make the required purchase if they have loaded the boat with debt. It would be best then that this company has a low amount of depreciation to profit's, as well as low debt as this puts them in a position of power and financial strength going forward.
R&D Spend to Profit
Companies with a competitive advantage achieve that advantage somehow, either through some technical process or by patent for example, and it usually costs a lot of money to do so. However some companies are able to hold their advantage easily while others constantly have to pour cash into staying ahead or catching up. So companies that have to constantly spend large amounts on R&D could be seen as companies in a highly competitive environment. For these companies it may not take much to lose their lead and this is especially true of certain industries such as auto makers or tech. So what we would like to look for (ideally) is a company that doesn't need to spend a great deal of its profits on R&D and hopefully a company that doesn't have to continually spend greater and greater amounts on R&D.
Interest to Profit
Interest paid out on debt; when compared to profit, gives us an idea of how affordable the interest payments for this company are. If a company is paying a lot of interest compared to its profits, it can spell danger. So to find a company that can easily afford its payments, we want to see this ratio as low as possible.
Net income shows the amount we have left after expenses and taxes have been accounted for. Obviously we want to see a positive figure here, but also, we would like to see consistency. If there is a gradual upward trend over the years even better.
Earnings to Revenue
This metric compares net income to revenue. This is useful in showing us how well a company is able to make money. If their earnings are only a tiny part of revenue, that means a large amount of money is lost in operating expenses, interest payments or tax for example. So ideally we would like to see an earnings to revenue ratio above 20%. What's more we also want to see consistency.
Cash Ratio & Current Ratio
Cash and cash equivalent's refers to liquid assets that the company holds. These are assets that can be used immediately. A company that is more liquid can easily cover its costs and react to unexpected (one off) expenditures.
Current ratio is a popular metric used by analysts that takes all current assets and compares them to current liabilities. If this number is 1 or above it indicates that all assets that can be liquidated with a year (current in accounting terms usually refers to a year period) are equal or greater than all the current liabilities. A company with a ratio lower than 1 may be in a tight spot when it comes to whether they can afford their liabilities (which include things such as short term debt payments, tax, payable invoices etc).
Short term debt to Long term debt ratio
Short term debt refers to money the company borrows that needs to be repaid in 1 year. Companies that borrow a lot of short term debt tend to be at the mercy of sudden economic changes. A lot of banks have spelled disaster for themselves by borrowing too much short term debt. The safest way to borrow is to borrow long term, so we like to see a company with little short term debt in comparison to long term.
Long Term & Short Term debt to equity
Long Term debt to equity
This is a simple metric which shows how much debt the company has in relation to their net worth. If this figure is close to 1 that would indicate that the company may be borrowing too much and may be considered a risky company.
Short term debt to equity
Is essentially the same as long term debt to equity. A higher ratio may pose liquidity concerns for this company.
Years to pay off debt
This metric compares long term debt to net earnings. It looks to give us an idea of how long it would take the company to pay off its long term debt using net earnings. Warren Buffett has historically chosen companies that could pay off their debt within 3 or 4 years.
After net earnings a company has a choice, it can pay dividends with its earnings, buy back shares, retain its earnings to help grow the business, or a little bit of each. In general, the more a company adds to its retained earnings, the higher its growth rate for future earnings will be. An increasing pool of retained earnings is a show of strength as well as advantage. Therefore we would like to see a steady increase in retained earnings over the years. If there is a sudden dip in this, we need to ask why.
When a company buys back shares, it can either cancel those shares or it can retain them. Great companies with plenty of cash like to buy back shares, so we would very much like to see an increasing amount of treasury stock (this is held as a negative number on the balance sheet, so we are looking for the negative figure to increase i.e. -$100 becomes -$200. For our graph we decided to convert treasury stock into a positive figure, therefore when looking at this graph you should be looking for a steady increase over time to the up side.
Return on shareholders equity
This is the value we get when we divide net earnings by shareholder equity. In our calculation we also account for treasury stock so the calculation is Net earnings divided by the total sum of shareholders equity and treasury stock. As a general rule, we want to see a company that is able to generate high returns. If returns in this metric are consistently low, I would stay away. What we would prefer to see are consistently high returns.
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So now that we have reviewed some of the key metrics for this company, why not comment below and let us know what you think about this company.
This blog only looks at a small part of this company's financials. If you would like to learn how to read financial statements in this way, take a look at the book linked below.
Source of financial data: https://quickfs.net/
data can at times be delayed or missing. Please check for the most up to date financial data before making any decisions regarding this company.