Now that we know how to read balance sheet and income statement, let’s go through some of the key numbers and ratios that help us in studying the financial health of a company. This is going to be a big read, so brace yourself!
EPS (Earnings per share): This number shows the total earnings per share of the company. We did see the trends in Net profit over the years earlier, so how is this number useful? The company could have issued more stock during the years which would lead to reduction in earnings available for each shareholder. Whilst issuing more shares (hence more capital) is not a bad thing in itself, it should not come at the cost of existing shareholders. If the company issues shares for mismanagement of capital rather than expansion, it is a red flag for any investor. (E.g. If you see large amount of debt and income not being able to support the interest payments, chances are that it will either issue even more debt or shares to get out of the trouble). While calculating the EPS, we should always include the stock options available for employees. EPS is expressed as below:
Net profit/(Total outstanding shares + Stock options)
A positive trend of EPS over the years is a good sign of earning power of a company.
RETURN PARAMETERS: RoE and ROIC
Return on Equity (RoE): Whenever we invest our capital in any stock/property/bonds/Fixed deposits, we look at what we earned. Instead of looking at the absolute return, we should look at the percentage earned for the whole capital invested to figure out if we are making good money. E.g. if you invest $100k in bonds yielding 3% coupon, you get $3k in one year. It is not the same as earning $3k on $20k investment in equities, right? That is because the second option gives you a more capital efficient method to make money. Earning 3% on bonds vs 15% on stocks for the same absolute return, but with lower capital (numbers are made up for concept basis).
Evaluating various businesses is the same as evaluating our personal investments. Checking the return on equity over the years gives us a good sense of whether the business is becoming more efficient or more productive. When we check this parameter across various companies in the same industry, it is more likely to help us pick up a quality business for our investment. This is calculated as below:
RoE (%) = Net income/Shareholders’ equity
Return on Capital Invested (ROIC): This parameter is very similar to RoE, except that we include the debt as well. As long as this number is higher than the cost of debt, we can be assured that business is making more than the cost of borrowing the money, hence adding to shareholder’s income (as was shown in previous chapter on Leverage). This is calculated as below:
ROIC (%) = Net income/(Shareholders’ equity + Total Debt – Cash)
The reason we deduct cash is that it can be used to pay off some portion of the debt. If this cash is not actively used in business activities of the company, it means that the management is still trying to find better investment opportunities. If they do not find such investment opportunities, they’d be better off paying off some debt or returning the cash to the shareholders in form of dividends or share buybacks.
LEVERAGE PARAMETERS: Debt/Equity and Interest coverage
From the previous chapter, we saw that leverage can be a powerful tool, but can be very harmful in bad business conditions. I’ll now give a brief on couple of ratios that can alarm us or make us comfortable about an investment opportunity.
Leverage (Debt/Equity): The ratio shows us the proportion of debt and shareholders’ equity in financing the business activities. We do not want this ratio to go higher than 1, i.e. the company should ideally not borrow more than what the owners have invested and accumulated over the years. That said, we should realise that some businesses require higher fixed capital like utilities/telecom etc., so those companies may have higher Debt/Equity ratio. In these cases, it is more prudent to understand the earning power of the companies and estimate if they could be in a potential problem. I tend to stay away from such companies (Debt/Equity > 1) since I believe we can always find good opportunities in companies with healthier financials.
Interest coverage ratio (EBIT/Interest expense): This ratio shows us whether the company is earning enough to meet the interest payments every year. If this ratio is lower than 1, it means that the company is not earning enough to pay the interest on its debt. This is definitely indicative of a business in trouble.
To calculate any of the numbers involving income, we should always exclude the extraordinary income (income not generated from operating activities). Extraordinary income could be in the form of a sale of assets or reversal of some reserves or a court settlement or any such reason which can not be directly attributed to normal business scenario. Please do note that the managements are well aware of the fact that the investors look at headline numbers like EBIT or Net income. Since investor confidence (and hence their compensation) is generally based on these numbers, management at some companies can be very enterprising in showing that the numbers are healthy but the facts could indicate otherwise. Hence, we should always look at the financial disclosure ourselves.
Chapter 18 – Cash flow statement (1)