The hidden treasures in company accounts Part 2 by Darren Winters

Many of the fundamental ratios can be found on financial websites although some figures you will have to calculate yourself. Ensure the websites you use have the most up to date information possible.

Always compare a company’s stock market valuation with others within its industry.

Following on from last month’s initial look at analysing company’s accounts, we shall conclude by continuing to look at key fundamental ratios. If you are the type of investor who loves to know what is fundamentally going on behind the scenes of a company, then going through these ratios will be of vital importance.

We shall also look at what the likes of Warren Buffett and Sir John Templeton regard as one of the most important fundamental requisites before they will even consider purchasing a company. Firstly, we shall continue where we left off…..

1. Operating cash flow to operating profit. This is a simple calculation to double check the believability of a company’s accounts. Divide the operating cash flow (cash flow from operations) by the operating profit (ie profit before interest, tax etc). The ratio from this calculation should always be greater than 1 as this shows that operating cash flow is greater than profit. How could you have a profit that is greater than cash flow? Unless a company has had to purchase new plant equipment, then cash flow should always be greater than profit and therefore you always want to see a ratio of over 1. If you see a ratio of less than 1, then be cautious because the company may have overstated profits by speeding up invoicing and slowing down payments to creditors. Like we said last month, don’t just take one years figures into account, you would need to check the past five years to ensure that cash flow is normally over 1.




2. Gearing. This measures the affect of borrowing in a company’s balance sheet. Include total borrowings (debt), both long and short term and include any bond issues and overdrafts. Deduct this from cash and short term investments and then calculate it as a percentage of total shareholders funds (this is the total of share capital and reserves and can be found on the balance sheet). A highly geared company is one that you may want to be cautious of whilst interest rates are rising, as the costs of servicing debt will eat into any profits they make. Alternatively, a highly geared company in a falling interest rate environment can do even better as their costs of servicing debt reduce.




3. The Acid Test. This ratio doesn’t work for all companies, but for manufacturing groups, it can be a vital calculation to make. Simply take the total current assets and then subtract inventories (stock). Divide this by the current liabilities and hopefully you will end up with a figure of at least 1. This ratio shows how liquid a company is but without including inventories. The reason for not including them is that if the company was being sold as a result of liquidation, the value of its stock will be far less than the value of it on the balance sheet.




4. Burn rate. This is a great way of assessing loss making companies if you are looking for shorting opportunities. The burn rate helps you calculate how long it will take for a company to run out of money. Take the last half years results and extract from it the cash operating expenses. Ignore depreciation and amortization but include salaries and administration costs. Take this figure and subtract the gross profit the company made over the period and then divide the result by 6 (this is the number of months over the half year period you are looking at). This gives you the monthly rate of cash consumption. Lastly, divide this monthly rate into the company’s net cash off its most recent balance sheet and the final figure will give you how many months the company can survive at its present rate of cash burn. One caveat—bare in mind a company in this situation could undertake a fund raising exercise in order to raise cash. Having said that, if it’s performing that badly, it may be refused funds from potential creditors etc.



5. Debtor and creditor days. This measures how quickly a company pays its bills and also how quickly its customers pay it. It is important to see how good a company is at maintaining its finances and keeping a good control on its debtors and creditors. Simply divide the debtors into sales and then divide by 365. This will give you the number of days it takes the company to get paid by its customers. To calculate creditor days, you simply use ‘cost of sales’ in the previous calculation. Like we have already stated, most companies will aim to slow down the time they take to pay their suppliers and speed up the time in which their customers pay them. However, if they delay paying suppliers for too long, it could be a sign they are in financial difficulty and will incur late payment fines and interest.




6. Depreciation. This is the annual reduction in the value of a company’s fixed assets. So if it bought new machinery last year that is expected to last for ten years, one can expect the value of that machinery to depreciate over the period. For that reason, company is supposed to set aside money to take into account this depreciation so that it will have the cash to replace the machinery when necessary. So you will need to look at what depreciation rate a company is using. If the depreciation rate appears too low, then you can safely assume that the company is not putting enough cash aside for future purchases of new plant. That will then impact its profits in the future. You should compare an individual company’s depreciation rate and period to that of its industry average. If it is too far adrift, that should raise a flag as it is probably getting boosted current earnings but will suffer at a later stage.

Lastly, we want to look at a ratio that some of the most famous value managers view as important. This is the Net Asset Ratio and whether a company is trading at a premium or discount to its net assets.

Although we can look at many measures of valuation, some of which are too obvious to have been included in this article, perhaps one of the best is the Net Asset Value as it is difficult to manipulated.

The calculation is simple, take the company’s total net assets (total assets less current liabilities, long term creditors, preferred stock and intangible assets) and then divide by the number of shares in issue.

If the figure you calculate is less than the price of the company’s shares, then it would be considered to be trading at a premium to net asset value (NAV). If the figure is higher than the share price, then it is considered to be trading at a discount to the NAV.

What a value investor will be looking for are companies that are basically good businesses, pay consistent dividends and yet are trading at a large discount to their NAV. Consider this; if a company went into liquidation today and it had to be sold off in order for shareholders to get their money back, you would want those assets to be worth more than the share price wouldn’t you? After the assets had been sold, shareholders would know they could get their money back.

If, however, a company was trading at a premium to its net assets and then had to be sold, shareholders wouldn’t stand a chance of getting all of their money returned because the assets were not enough to match the share price. Caution should be used when looking at NAV. Some companies may be trading at a discount to it today, but what if they had to write off machinery due to technological change?

This happened to many engineering companies when new technology improvements caused them to have to write off their plant and so all of a sudden, they weren’t as attractive from a NAV point of view. You want to ensure that not only is a company trading at a discount to NAV, but it also has a competitive edge and solid growth prospects based on its product range and equipment.

BRINGING IT ALL TOGETHER

By looking at the many fundamental ratios and figures, we are hoping to find quality companies that have good growth prospects and yet are currently considered cheap. This can be more difficult in practice because although you can often find undervalued companies, they will be that way for a reason. They could have poor management, under-perform their industry sector, be discounted because of the nature of their business, plus many more reasons.

However, you can often find a company that has simply been overlooked by the investment community in their search for more ‘exciting’ stocks. This is when you can find yourself a stock that is currently cheap but has a good future ahead of it. Along with that should be increasing dividend payments and an elevating share price.

Like we stated in the first part of this article last month, companies with high levels of cash can be very attractive. As long as they have a solid management on board, you should be confident that they will either put it to good use or return it to shareholders through dividends.

Also, when looking at undervalued companies, sometimes the value of their stock or assets can increase. This can be true for building companies and mining operations where the price of the mined product is rising (such has been with gold, silver etc over the past few years). Just a couple of months ago we discovered a mining company whose assets under the ground were worth many times what its market cap was valued at.

Although many fundamental ratios can be found on websites and paid for analysis platforms, crunching a company’s accounts will give you more information than you can otherwise gather. For long term buy and hold type investors, this type of analysis can prove valuable to the future success of your portfolio.

Warren Buffet always looked for companies that were trading at discounts to their net assets and this strategy, combined with other fundamental research has served him well.

Good sites for fundamental information include reuters, Bloomberg, zacks, yahoo and even comdirect based in the UK.

Darren Winters