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NEXT ARTICLE Debt Ratios - Tools for Finding Safer Shares (Part 1)

For many investors financial analysis forms the foundation of their investment decision.  In their minds, it is the essential component in the process of evaluating a company as a potential share market investment.  By digging into the crown jewels of a company’s annual report -the income statement; the statement of comprehensive income; the balance sheet; the cash flow statement: and the statement of changes in equity – the investor hopes to learn four things about the company’s current and future condition:

1.    How Profitable is the company? How likely is it to remain so in the future?

2.    How Solvent is the company?  Is it carrying too much debt?

3.    How Liquid is the company?  Is there enough cash on hand to handle short-term needs?

4.    How Stable is the company?  Can it remain in business over the long run?

A professional financial analyst extracts performance numbers from the company’s financial statements and turns them into a wide variety of ratios that serve as indicators of performance.  There are literally hundreds of different ratios used by professional analysts to determine a “buy, sell, or hold” recommendation on a company’s shares.  

What is the individual investor to do?  If you have followed the track record of some financial analysts, you know they are often dead wrong.  Many investors prefer to make their own decisions, or at least to know enough to investigate a buy recommendation on their own.

For the average investor a simpler way to sort through the maze of available financial analysis information is to follow the money as you read through a financial statement.  Cash is king and using other people’s money – debt – to grow the company is sometimes a good thing.  Here are some of the things to look for in financial statements:

– Where does the company’s cash come from and where does it go?

– Are increases in earnings due to increases in top line revenue or due to bottom-line cost cutting?

– How much cash does the company have on hand?

– How much do they owe?  Can they handle that amount of debt?

There are financial ratios to help you answer those questions and you do not have to calculate them on your own.  They are readily available on financial websites.  What’s more, you can boil down the multitude of available ratios into five broad categories:

1.    Profitability Ratios

2.    Operating Ratios

3.    Leverage Ratios

4.    Liquidity Ratios

5.    Solvency Ratios

Profitability and Operating ratios tell you how much money is coming in the door and how efficiently it is turned into profit.  These are the ratios that show the money coming in.

Leverage, Liquidity, and Solvency ratios tell you how exposed a company is with its debt and how much capital is available to meet current debt obligations.  These are the ratios that show you where some of the money is going.

When all is said and done, no matter how diligent your efforts are at evaluating a company, you will still be missing a critical piece if you restrict your homework to the financial performance of the company in isolation.

Think of individual companies as boats operating on an open sea.  Think of the sea as the market in which the company operates.  In today’s economy, more and more companies operate in a global market and macro-economic conditions in those markets can rock those boats and even sink some of them.

As an example, let us look at three of Australia’s largest companies.  BHP Billiton is the largest company in Australia and Rio Tinto is the fourth largest.  The second largest is National Australia Bank.

Both BHP Billiton and Rio Tinto are dual listed companies.  They have corporate headquarters in both Australia and in England.  If you look into the financial statements of the National Australia Bank, you will see they derive significant income from operations in both the United Kingdom and in the United States.

Although the Australian economy is arguably the soundest in the industrialized world right now, companies like BHP, RIO, and NAB are exposed to the banking system in England, and to a lesser degree in the United States.

There are those who argue the Great Recession of 2008 came about when the United States investment banking house, Lehman Brothers, went bankrupt.  In the banking business banks borrow from other banks to have the capital needed to make loans.  Banks across the world sustained losses in the Lehman failure and the result was a worldwide credit freeze.  Banks were afraid to lend, even to each other.  Businesses need credit and without access to it, the global economy sputtered.

Today we read of a debt crisis in Europe and major troubles with British Banks.  Does it take a crystal ball to predict that severe financial troubles in Britain could affect Australian companies like BHP and Rio Tinto; and Australian banks like NAB?  

Is this a reason not to buy shares in one of these companies?  Not really, but it may be a reason to sell if the credit picture globally begins to deteriorate again.  The critical point here is that you will not find this potential macro economic risk anywhere in the financial statements of any of these companies.  Analyzing the future of a company’s performance needs to go beyond the numbers.  It is not just about the boats themselves; it is also very much about the seas on which they float.