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Stocks and inflation (Theory of investment value). Why should an investor pay more in sound money today simply because a stock is going to be quoted higher in depreciated money tomorrow?
Think of our investment portfolio as an investment company. Dividends = revenue.
Focus on look through earnings by calculating the underlying earnings attributable to the shares you hold in your portfolio. The goal of each investor should be to create a portfolio (in effect, a “company”) that will deliver the highest possible look-through earnings a decade or so from now.
Target look-through earnings growth of about 15% annually.
The statement of cash flows should reconcile revenue and cost flows with changes in overall financial position.
FCF = net cash from operating activities - capex including investment in software minus acquisitions + average acquisitions
FCF is the excess cash an owner can pocket after paying all expenses and making whatever investments are necessary to maintain the business.
FCF is the well from which all returns are drawn (dividends, stock buybacks or investments capable of enhancing future returns).
FCF may be much higher than net income due to charges to net income to amortize intangible assets picked up in acquistions.
Not all growth is good. Not all growth is equal.
Growth requires additional investment, achieving more sales almost invariably requires more current and fixed assets. The principal determinant of the value of growth is the relationship between the return on the new capital required to fund the growth and the cost of that capital. As long as the return on capital and cost of capital are the same, growth never adds value to the business.
For an increase in profits to be evaluated properly, it must be compared with the incremental capital investment required to produce it. Compare change in net tangible assets (essentially reinvested earnings) to growth in (pre-tax?) income over the period. The remaining pre-tax profits presumably distributed as dividends or added to retained earnings?
Many businesses income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings).
Earnings rarely increase, at least not for very long, without a corresponding increase in sales. And sales hardly ever grow substantially without an increase in the amount of assets the company needs to employ.
Profitable growth means growth in earnings in excess of the cost of the investments needed to pay for the assets that support that growth. [Value Investing pg 110] Otherwise the company is just breaking even, economically speaking.
Contingent consideration is classified as a liability or equity and is measured at fair value on the acquisition date. Contingent consideration that is classified as a liability is remeasured to fair value at each reporting date, with changes included in the income statement in the post-combination period.
Watch for big gains from reductions of contingent consideration liability. Contingent consideration reserve is a liability on the balance sheet for a future payout if the business hits targets. If however the unit underperforms then the reserve is reduced and in turn a credit is applied to operating expense (increasing profits despite underperforming!).
For acquisitive companies use FCF after acquisitions to assess cash generation. Could use average acquisitions since they don’t occur every year.
In the presence of a significant acquisition crunch the numbers in order to parse out the underlying growth rates of the legacy business, the acquired business and the combined business (refer to proforma footnotes and review both parties disclosures on the merger of businesses to best grasp the true economics of the transactions).
An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.
On occasion, a ridiculously high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance.
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
Confine universe to cash generating franchise business. Cash generating is defined as operating earnings plus depreciation and amortization less capital expenditures for the maintenance of the franchise (EBITDA - CAPEX).
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. From Berkshire Hathaway Letters to Shareholders.
Look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.
The primary factors bearing upon the evaluation are:
Excellent businesses that benefit from a durable competitive advantage and can consistently earn high rates of return on retained earnings (shareholder equity) are often bargain buys at what seem to be high price to earnings ratios. The growing equity pot and the earnings that go with it are what interests us.
Add cash(net), marketable securities and any other investments in other companies to final valuation.
Don’t double count dividends. Dividends don’t affect profit on the income statement, they only affect the cash flow statement and retained earnings/shareholders equity on the balance sheet.
Using discount dividend model, use average augmented dividends as buybacks vary from year to year.
Low prices creates huge volume. Eg Walmart’s low operating costs of about 20% of sales allow Walmart to sell at prices that high-cost competitors can’t touch and thereby constantly increases its market share.
Accounting goodwill is essentially the amount by which the purchase price of a business exceeds the fair value of the assets acquired (after deducting liabilities).
When a management acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own.
Economic goodwill (different to accounting goodwill) is the combination of intangible assets, like brand name recognition, that enable a business to produce earnings on tangible assets, like plant and equipment, in excess of average rates.
While accounting goodwill decreases over time, economic goodwill tends to increase over time, at least nominally in proportion to inflation for mediocre businesses, and more than that for a business with solid economic or franchise characteristics.
High return on net tangible assets indicates the existence of economic goodwill far larger than the total original cost of accounting goodwill. (Essays of Warren Buffett 4th ed Loc 4800)
Warren considers 21.0% pretax return on tangible net worth to be good.
What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operations economic goodwill (Essays of Warren Buffet 4th ed Loc 4851)
Return on unleveraged net tangible assets = net income – amortization charges/ Total assets – goodwill – intangible assets
Return on unleveraged net tangible assets = owner earnings/ Total assets – intangible assets (but not goodwill as this is reinvestment) + add back debt
“Water” in the balance sheet might come in the form of goodwill or concealed by an overvaluation of the fixed assets (ie property investment accounts). Compare Total Assets and Total Tangible Assets.
An area of difficulty is the valuation of intangible assets -product portfolios, customer relationships, trained workforce, brand recognition – many of which do not even appear on a firm’s balance sheet. You can estimate the cost of replicating product portfolios, assuming these are not protected by patents, using historical research and development data.
Apple, Coca Cola and Google have very little goodwill/intangible assets on their balance sheets even though their brands are worth billions. Making comparisons between tangible assets and total assets will reveal this.
Berkshire Hathaway Letters to Shareholders 1984 Appendix,Loc 3713 Goodwill and Amortization
Make a comparison between earnings and net tangible assets. Accounts receivable is included as a tangible asset.
e.g. See’s in 1972 was earning $2m after tax on $8m of net tangible assets with no financial leverage (a return of 25% after tax on net tangible assets). This performance indicates the existence of economic goodwill. Berkshire paid $25m for See’s (12.5x earnings or 3 x net tangible assets)
Berkshire 2007 letters: Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth — and somewhat immodest financial growth — of the business. In the meantime pre-tax earnings have totalled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.) There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments. A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
Consider a hypothetical mundane business also earning $2m but needing $18m in net tangible assets for normal operations. Earning only 11% on required tangible assets, that business possesses little or no economic goodwill. Such a business might well have sold for the value of its net tangible assets or $18m. Consider the effect of inflation doubling. Earnings would have to double (eg double prices) to $4m. But to bring this about both businesses would probably have to double their nominal investment in net tangible assets. See’s would have to commit an additional $8m but the mundane business would need $18m of additional capital. The mundane business would now be worth $36m and See’s would be worth $50m. Businesses needing little in the way of tangible assets are hurt the least by inflation. Asset heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses. In contrast great business fortunes built up during inflationary years arose from ownership of operations that combine intangibles of lasting value with relatively minor requirements for tangible assets.
When evaluating the underlying economics of a business amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operations economic goodwill.
In the context of valuation, the working capital needs of the firm have to be taken into consideration in calculating the cashflows to equity.
The accounting definition of working capital includes cash in current assets. This is appropriate as long as the cash is necessary for the day to day operation of the firm. Any cash beyond this requirement should not be considered in calculating working capital for the purposes of cashflow calculation, since an accumulation of cash above that necessary for day to day operations is not a cash outflow. This is particularly relevant when valuing companies such as Apple with excess cash on the balance sheet.
The working capital needs of a firm will in large part be determined by the type of business it is in. Retail firms have a much higher need for working capital, as a percentage of revenues, since they have higher inventory and credit needs than do service firms (though note that Walmart has negative working capital as it takes a long time to pay its suppliers).
Furthermore, the changes in working capital will be correlated to the growth rate of the firm. In general, higher growth firms can expect to have much larger increases in working capital than lower-growth firms in the same line of business.
Growing businesses have working capital needs that increase relative to sales growth and significant requirements for fixed asset investments. A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment but it is far better to have an ever-increasing stream of earnings with virtually no major capital requirements.The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money (think airlines).
The failure to consider working capital needs in valuation will result in the over estimation of cashflows to equity and the value of equity in the firm.
A decrease in working capital requirements in any one year might result in increased free cash flows even though net income might be lower.
Test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. Apply this test on a five year rolling basis.
Shareholder value
Does managements investment of retained earnings appear to have increased per share earnings and therefore shareholder value? 1.Add up eps for last 10 years. 2.Add up dividends for last 10 years Retained earnings = 1-2
The current earnings are caused by the competitive advantage and management skill in investing the retained earnings of 1 -2 over the last 10 years.
We can argue that the retained earnings of 1 -2 produced an additional income of eps- (eps-10) for the current year for a return of:
(eps) –(eps-10)/ retained earnings (1-2)
The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. A bond has a coupon and maturity date that define future cash flows, but in the case of equities, the investment analyst must himself estimate the future “coupons”.
Determine the right time/price to buy at. Calculate the initial rate of return (IRR). Above 7% is good if the return is expected to keep growing (at say 8% per year). What will my rate of return be in 10 or 20 years time? 40%? The less you pay for the stock the higher the IRR and this will compound over time if the company has a competitive (durable) advantage. Project earnings over 10 years to predict the future rate of returns.
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Eg company xyz trading at $60 a share and we expect to receive $100 cashflow (or profit) at end of 10 years:
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(expected yield or potential rate of return)
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Using a 3% discount rate to work out PV of $100 in 10 years. In other words buying XYZ for $74.41 today you’ll earn 3% annually for the next 10 years.
Determine the right time/price to buy at. Calculate the initial rate of return. Above 7% is good if the return is expected to keep growing (at say 8% per year). What will my rate of return be in 10 or 20 years (40% would be good)?
The discount rate is the required rate of return for investing in a stock given its risk.
Calculate discount cash flow using rates of 10%, 12.5%, 15% and 17.5%.
Owner Earnings = (a)reported earnings plus
(b) depreciation, depletion, amortization and certain other non-cash charges
Less (c) the average amount of capitalized expenditures for plant & equipment etc that the business requires to fully maintain its long term competitive position & its unit volume (if the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional WC if unit volume does not change).
Return on Equity (ROE) is extremely important for assessing the effectiveness of managements ability to reinvest profits in the business.
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share.
ROE captures all aspects of how shareholders money is employed. It does not matter whether the money has been used on new equipment or the company paid too much for acquiring a competitor. The net income must follow the investment level to maintain steady ROE.
Generally speaking, a company that takes on good projects should have a ROE that exceeds its cost of equity. Since increasing leverage also increases the cost of equity, the ROE will have to increase by more than the cost of equity for higher leverage to be in the best interest of the company.
Increasing leverage will lead to a higher ROE if the pre-interest, after-tax return on projects (assets) exceeds the after-tax interest rate paid on debt.
Look for steady/increasing trend of ROE of 8% over a period of ten years but note that it differs per industry.
A company that borrows money to finance projects and earns a ROA on those projects that exceeds the after-tax interest rate it pays on its debt will be able to increase its ROE by borrowing.
High D/E may equal a ROE mirage. Increasing leverage will lead to a higher ROE. ROE of 10% with zero debt (D/E=0%) is equivalent to ROE of 20% with 50% debt (D/E=1.00).
As ROE includes debt in the equation you can adjust for debt to compare companies with debt to companies without debt.
Is this not the same as the return on assets calculation?
ROE might also be skewed if the company holds excess assets such as cash earning a low interest rate. So adjust for excess cash:
ROE=(earnings-interest income)/(equity-cash) Debt-to-equity ratio = (Interest bearing Long term debt+notes payable) / equity.
Choose companies with a D/E of below 0.5 and you will most likely end up with companies with lower ROE, but they will likely be more sustainable in the future.
You should look at the value and trend of ROE with one eye, and the financing structure (D/E) with the other.
Return on assets eliminates the effect of debt upon returns. If the company had no debt, the Return on Assets (ROA) and ROE would be the exact same number. If you are analysing a company with a lot of debt, you will probably want to use the ROA instead of the ROE.
ROA = net income/Total Assets. (Total assets = all assets from goodwill to inventory).
ROA will always be lower than ROE if the company has debt. This is because Assets = equity + liabilities.
ROE and ROA calculations are distorted by ignoring differences between reported equity & assets and between tangible equity & assets in addition to distortions due to differing tax rates and debt levels.
Focus on whether ROA is higher than competitors rather than above a specific amount but generally ROA should be over 6%.
A major driver behind the validity of ROE is the company’s financing structure. A company can be financed with equity or debt or a combination of the two.
Be cautious about companies with a debt-to-equity ratio of higher than 0.5.
ROE captures all aspects of how shareholder’s money is employed. It does not matter whether the money has been used on new equipment or the company has paid too much to acquire a competitor. The net income must follow the investment level to maintain a steady ROE.
Debt and cash adjusted ROE = earnings-interest income/(equity+debt-cash)
Economic Goodwill and High Return on Net Tangible Assets High return on net tangible assets indicates the existence of economic goodwill far larger than the total original cost of our accounting goodwill (Essays of Warren Buffet 4th ed loc 4800)
Protection against inflation. A doubling of inflation would mean a doubling in the companies nominal investment in net tangible assets. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories.
During inflation, goodwill is the gift that keeps giving. But that statement applies, naturally, only to the economic goodwill. Spurious accounting goodwill is another matter. When an over-excited management purchases a business for a silly price, the same accounting niceties are observed. Because it can’t go anywhere else, the silliness ends up in the goodwill account. The 40 year ritual is observed and the adrenalin so capitalised remains on the books as an “asset” just as if the acquisition had been a sensible one.
What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortisation of goodwill is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operations economic goodwill.
Return on unleveraged net tangible assets = (net income + amortisation charges) / (total assets – goodwill – intangible assets) Managements usually detest purchase accounting because it almost always requires that a “goodwill” account be established and subsequently written off – a process that saddles earnings with a large annual charge that normally persists for decades. In contrast, pooling avoids a goodwill account, which is why managements love it.
“Eventually amortization charges fully write off the related asset. When that happens – most often at the 15-year mark – the GAAP earnings we report will increase without any true improvement in the underlying economics of Berkshire’s business.” Berkshire Hathaway Annual Report 2016 pg 15.
Evaluating companies with debt If cash substantially exceeds notes payable then debt can ordinarily be dismissed. If debt is larger than cash then it is clear the company is relying heavily on the banks.
Study the debt over a period of years to see whether it is growing faster than sales and profits. If they are this is a definite sign of weakness.
Evaluate the default risk by looking at interest coverage ratio which examines the capacity of the company to meet interest payments (but doesn’t measure the ability to pay back the outstanding debt)
interest coverage ratio = earnings before interest & taxes / interest expenses
The denominator in the interest coverage ratio can easily be extended to cover other fixed obligations such as lease payments. If this is done, the ratio is called a fixed charges coverage ratio:
fixed charges coverage ratio = Earnings before interest, fixed charges & taxes/ fixed charges
Both interest and fixed charges coverage ratios are open to the criticism that they do not consider capital expenditures, cashflows that may be discretionary in the very short term but not in the long term, if the company wants to maintain growth. One way of capturing the extent of this cashflow, relative to operating cashflows, is to compute the ratio of the two:
operating cashflow/capex ratio = cashflows from operations/capital expenditures
While there are a number of different definitions of cashflows from operations, the most reasonable way of defining it is to measure the cashflows from continuing operations, before interest but after taxes and after meeting working capital needs.
cashflows from operations= EBIT(1-taxrate)-Change in working capital
You can evaluate the company’s capacity to pay back the principal on outstanding debt using the debt ratios:
debt/capital ratio = debt/(debt+equity)
debt/equity ratio = debt/equity The first ratio measures debt as a proportion of the total capital of the firm and cannot exceed 100%. The second measures debt as proportion of the book value of equity in the firm
What to include in debt:
a) hybrid securities = part debt, part equity, like convertible bonds and preferred stocks. Estimate the debt and equity components separately for hybrid securities and add these components to their respective sides.
b) off-balance sheet commitments such as contingent liabilities. General rule is to ignore contingent liabilities that hedge against risk since the obligations on the contingent claim will be offset by benefits elsewhere.
c) leases. capitalized leases are now shown as part of debt, but operating leases are not. Since a fine line separates the two, the conservative approach to estimating debt ratios will capitalize operating leases and show them as part of debt.
d) Pensions. Firms generally include in their debt the excess of accumulated benefit obligation over the pension fund assets. Here again, a conservative estimate of the debt ratio will consider projected benefit obligation over pension fund assets.
e) Debt of non-consolidated entities. Firms generally do not have to show as a liability that debt that is owed by their nonconsolidated subsidiaries, even though they may have guaranteed and stand liable for that borrowing. The conservative approach will add this debt to the firms total debt and compute the debt ratio on that basis.
Book Value = Total Assets – Total Liabilities
Book value per share = common stock + surplus items – goodwill and intangibles num of shares outstanding
Surplus items means not only items clearly marked as surplus but also premiums on capital stock and such reserves as are really part of the surplus (voluntary reserves) eg reserves for preferred stock retirement, for plant improvement and for contingencies (unless known to be actually needed). Reserves of this character may be termed “voluntary reserves”.
[Page 549 sixth edition of security analysis]
Book value per share = tangible assets – liabilities and stock issues ahead of the common/num of shares outstanding
Common stock + surplus + voluntary reserves (contingency & other reserves, insurance reserves, capital surplus, earned surplus)
Earned surplus = retained earnings
Surplus= Accumulated OCI
Per share earnings may be the choice of those in control and may be made to appear either larger or smaller. *By allocating items to surplus instead of to income, or vice-versa *By over or understating amortization and other reserve charges. *By varying the capital structure, as between senior securities and common stock *By the use made of large capital funds not employed in the conduct of the business.
A beta above 1 more exposed to market risk and below 1 less exposed.
Earnings on invested capital page 83 interpretation of financial statements.
Earnings on invested capital = total income (EBIT?) – funded debt + companystock + preferred stock + common stock + surplus
Capitalizing = recording of costs on the balance sheet as an asset.
Detect improper capitalization of line costs by checking trend of cash flow from operations minus capital expenditures (the money is still paid out), big decline in FCF with equally sizeable increase in cash flow from operations, unexpected increases in capex that belie the company’s original guidance and market conditions, unwarranted improvement in profit margins and a large jump in certain assets (usually described as deferred assets). Look for new or unusual asset accounts (particularly one that is increasing rapidly).
Capitalization of software costs = shifting significant costs to balance sheet to inflate profits
You want to invest in a company that sells something people use every day but wears out quickly.
A good rule of thumb would be to add up the expected per share earnings over the next ten years and then compare that sum with what you would earn if you invested in bonds instead.
Amortization of leasehold improvements is similar to depreciation. Leasehold improvements must be written down to zero by the end of the leasehold.
Corporate Pyramiding/ Subsidiary losses should be deducted! Holding company structure facilitates market manipulation eg holding company earnings exaggerated by payment of stock dividends exceeding current earnings (unearned dividends of subsidiaries). Check credit or debit to earnings for undistributed profit or loss of subsidiaries. Adjust for undistributed earnings or losses of subsidiaries.
Compensation based on unreliable non-gaap metrics (adjusted earnings and adjusted revenue where these greatly inflate true performance.)
If book value is understated (eg not adjusted for research asset or capital value of operating leases) the return on capital will be understated. R&D should be treated as capex and the amortization of the research asset as part of depreciation.
Review offbalance sheet purchase commitments that may be more significant than the liabilities recorded on the balance sheet.
Reserves are usually created by a charge to surplus.
Check adjustments to surplus. Charged against surplus and therefore not shown in the income statement (pg 422 sixth edition)
Pay attention to deferred charges on balance sheet and annual charges to income to write it off.
Income statement income without depreciation and interest charges.
Look for changes to accounting policy (compare years) and surging long-term and total receivables for evidence of aggressive revenue recognition. Use days sales outstanding (DSO) to evaluate how quickly customers are paying their bills relative to how quickly revenue is recorded. A higher DSO could indicate more aggressive revenue recognition in addition to simply poor cash management. An increase in DSO can often be an indicator that more products were shipped late in a quarter than usual. Bogus revenues come with bogus receivables.
Compare revenue growth to net income growth (Efficiency savings can’t go on forever).
Historical growth: focus on revenue growth which tends to be more persistent and predictable than earnings growth).
Deferred/unearned revenue = a reserve that can be released in a future period. Watch for changes in these reserves. Pg 120. Eg Amazon unearned revenue relates to gift cards or amazon prime membership.
Watch for large gains from ineffective hedging/derivatives. Also watch investing gains.
Tech companies pay staff in stock. If stock price doesn’t keep rising staff will demand higher cash salaries.
Quality of earnings check. Look for any disparity between income and cash flow from operatons.ie negative cash flow from operations and positive net income.
Operating income = earnings generated by the actual operations of the business. One time write offs eg to write off inventory or plant and equipment effectively shift the related expenses (ie cost of goods sold or depreciation) out of the operating section to the nonoperating section and so boost income [Watch for companies constantly recording “ restructuring charges”]. Income statement Balance sheet Cost of goods sold Sale of goods Inventory
Form a complete income statement including:
Ratios Debt-equity ratio. If it exceeds 0.5 understand how the company got there. If the company's debt is increasing try to understand why.
Current ratio=current assets/current liabilities. Threshold is that it should be over 1,0, or 1.5 to be safe. It's expected that money going out will not be higher than money coming in. (or the company will be forced to take on debt). There is a trade-off between minimizing liquidity risk and tying up more and more cash in working capital (w/c = current assets minus current liabilities)
Inventory Turnover Ratio = Cost of revenue/Inventory. Shows the speed at which a company turns inventory into sales. Capital in inventory is expensive. Research industry standard but take inventory turnover of 4 as a rule of thumb for products with a high duration.
Accounts Receivable Turnover = turnover/accounts receivable. To make this more meaningful convert it into days by dividing 365 by the turnover ratio. This is a nice key ratio to keep an eye on if the company sells a lot on credit. How quickly does the company get it's money? In other words how quickly does the company turn accounts receivable into cash? Accounts Payable Turnover = Cost of Revenue/Accounts Payable. Convert to days by dividing 365 by the turnover ratio. Shows how long the company takes to repay suppliers. A high accounts payable turnover ratio means the company pays back suppliers quickly, therefore no problem honouring debt obligations. Free cash flow = operating cash flow + property, plant and equipment, net. Property, plant & equip is sometimes referred to as capital expenditures/CAPEX and we assume spent to maintain and develop the business. Look to invest in businesses with high and stable free cash flow. Investing-cash-flow-to-operating-cash-flow-ratio = investing cash flow/operating cash flow. eg 1653/3098 = 53.3% means that for every $100 in cash from operations, $53.3 in cash are spent on maintaining and investing in the company's growth. The question is, are these cash investments for growing the business or cash outlays for maintaining the existing business?