What is the most recent information available to stock holders and prospective buyers to help them make their minds up whether a company would be able to meet their financial obligations or not? If its stock is listed on a major exchange, they are required to file quarterly reports with the SEC in a "timely" manner. If you're considering a smaller or private venture, you can get the same information by asking the company for it. You would want the quarterly balance sheets, income statements, and cashflow statements from the most recent two or three years to answer this question. If the company doesn't have strict SEC reporting requirements, insist on audited financial statements. If they can't or won't provide them, walk away. If you're asking this question, there's no way you can come out a winner in that kind of situation.
For what follows, I'm going assume you're using quarterly financial statements. If you can only get annual statements, wherever you see "multiply by 91", read that "multiply by 365" (converting days in a quarter to days in a year), and where I tell you to multiply by 4 (converting a quarterly value to a yearly value), just skip it.
On the balance sheet, you are looking for debts outstanding in relation to short-term assets (typically listed as "cash and cash equivalents", "short term investments", "accounts receivable", and "inventory").
You want the company to have enough cash on hand to cover their foreseeable near-term expenses, but not a whole lot more than that - if they're holding on to too much cash, they're either anticipating some rough terrain ahead, or they're not very good at allocating capital (which will impact returns). If they don't have enough cash on hand, they may be forced to borrow to pay their near-term operating expenses. This is not necessarily a bad thing - if the company is growing, it may need more cashflow than it can generate on its own.
You also need to see how efficient your prospective investment is about getting paid. So, take the accounts receivable amount, and divide it by the "revenue" figure from the matching income statement. Then, multiply the result by 91. That's roughly how many days it takes the company on average to go from a signed contract to cash in hand. By itself, it's probably not terribly meaningful. However, if you calculate this value for the past several quarters, you can see if there are any ominous trends showing up. For example, if the value was 45 for two or three quarters, and then shoots up to 65, it could mean that the company signed several worthless contracts, or the sales folks have been engaging in a charming practice known as "stuffing the pipeline" - they send out demonstration models and book it as a closed sale, and the company keeps the sale on their books until their credit department gets around to recovering the demo model months later. I was working at a privately held company where this happened, and it almost bankrupted us.
You also want to see how efficient your new investment is about selling its inventory. You can calculate how frequently inventory turns over by dividing the revenue figure by the amount in the inventory account, and multiplying by four. This is how many times they are able to sell all of their inventory per year. Again, you want to watch out for sudden, large changes in this number.
Turning to the income statement, you want to see how effective they are at converting revenue (the top line) into income (the bottom line). There are several different categories here, but the basic ones to look at are revenues, cost of goods sold (or "cost of revenue"), operating expenses, and anything under "operating income" that looks like it's fluctuating wildly. The ratio of "operating income" to "revenue" is the operating margin - you want this to be relatively steady or increasing. You also want to look out for the ratio between cost of goods sold (or cost of revenue) and revenue - if this ratio is increasing, it could mean that the company is looking at higher prices from suppliers that it can't pass on to its customers. You also want to see more or less steady increases in both revenues and net income.
Finally, you should look at the cash flow statement. You want to see a values that are fairly predictable (follow an easily defined trend), particularly with operating cash flow and capital expenditures.
If the numbers look okay at this point, you can take the most recent balance sheet, and look at the "current liabilities" value. If this is less than the most recent net income or net cash flow (whichever's less) multiplied by 4, the company can pays its current obligations, and will probably be able to do so in the future. If not, there could be trouble.
If the numbers don't look okay, you will probably want to see income or cashflow that's at least double or triple the current liabilities amount to feel safe (and the wackier the numbers, the more margin of safety you'll want to see). Published financial statements. The company's balance sheet. If you request one, they'll have to give you one. this is, in part, what fundamental financial analysis of company statements is all about.
just getting the statements likely isn't enough -- you have to be able to analyze them well and that requires some training, skill, and work. |
