In order to become a serious investor, you have to roll up your sleeves and do some dirty work. While it’s still smart to listen to what other experts say, you have to do your due diligence so that you know which companies are worth a second look.
How to analyze a company’s financials
As an investor, you must learn how to move past subjectivity and become an objective judge of a company’s present and future value. In a world where marketing, advertising, and clever branding shape the marketplace’s perception of different businesses, this isn’t always easy to do. The only solution is to cut through the noise and dig into the numbers. Because if there’s one thing you should know, it’s that the numbers rarely lie.
As you analyze a company’s financials, there are certain metrics you should look for. In particular, you’ll need to keep an eye out for the following:
1. Current assets and liabilities ratio
When you analyze a company’s assets and liabilities, you’ll find they’re broken down into current and non-current items. Current assets and liabilities refer to items with an expected life of 12 months or less. For example, this may include inventory that’s expected to be sold within the next year.
The “current ratio” takes a company’s current assets divided by their total current liabilities. This metric is useful in assessing the company’s ability to meet short-term goals and obligations. You want a ratio that’s not so low that it indicates insolvency, but not so high that it reveals an unnecessary pile of cash that isn’t being used in an adequate manner.
2. Non-current assets and liabilities
A company’s non-current assets and liabilities refer to items that have lives expected to last beyond a year and into the future. Generally speaking, a company’s biggest non-current assets and liabilities will include things like real estate, buildings, equipment, and long-term debt.
Again, the best way to analyze non-current assets and liabilities is to look at them in ratio form. This gives you a way to compare over time and contrast against other companies.
3. Market-to-book multiple
This is a really important metric to look at. By comparing a company’s market value to its book value, you can get an idea for whether a particular stock is under- or over-priced.
While not a perfect metric, the market-to-book multiple is helpful in making quick assessments. If you see numbers that look like outliers, you should dig in and see what’s really going on. You may find that the ratio misleading, but you may also discover an opportunity.
4. Operating expense ratio
The operating expense ratio (OER) is one of the more important financial KPIs you can look at. It shows the operational efficiency of a company by comparing operating expenses to total revenue. The lower the expenses are, the more profitable the company will be (theoretically).
For example, let’s say a company’s operating expenses were $1 million last year and its revenues were $5 million. You would divide $1 million by $5 million and get 20 percent. This indicates that the company has a great deal of financial flexibility and has plenty of room to maneuver.
5. Liquidity
“Liquidity is a key factor in assessing a company’s basic financial health,” J.B. Maverick writes for Investopedia. “Liquidity is the amount of cash and easily-convertible-to-cash assets a company owns to manage its short-term debt obligations. Before a company can prosper in the long term, it must first be able to survive in the short term.”
Liquidity is often determined by calculating a quick ratio. Anything lower than 1.0 indicates the possibility of danger. It shows that liabilities exceed assets and that a company may be facing trouble.
6. Solvency
Often discussed in tandem with liquidity, solvency is a company’s ability to meet debt obligations on a rolling basis. If liquidity looks at short-term health, solvency is an analysis of long-term debt in relationships to current assets.
Know what you’re looking for
You can’t base your investment decisions on brand perceptions or “expert” advice. While you may occasionally receive smart suggestions, this method will eventually fail you. The only way to consistently make smart investing decisions is to dig in and perform the research and analysis firsthand. At the very least, this will make you an informed investor who is capable of making strategic and objective decisions.
Disclosure: I do not own any of the stocks mentioned in this article.
