Saturday, March 22, 2008

How to Evaluate a Company before Investing

For stock investors that favor companies with good fundamentals, a "strong" balance sheet is an important consideration for investing in a company's stock. The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In this article, we'll look at evaluating balance sheet strength based on the composition of a company's capital structure.

A company's capitalization (not to be confused with market capitalization) describes the composition of a company's permanent or long-term capital, which consists of a combination of debt and equity. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness.


Clarifying Capital Structure Related Terminology
The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization, i.e. a permanent type of funding to support a company's growth and related assets.



A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. Investors should understand that there is a difference between operational and debt liabilities - it is the latter that forms the debt component of a company's capitalization - but that's not the end of the debt story.

Among financial analysts and investment research services, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a company's capitalization is simply a balance sheet's long-term debt. This definition is too simplistic. Investors should stick to a stricter interpretation of debt where the debt component of a company's capitalization should consist of the following: short-term borrowings (notes payable), the current portion of long-term debt, long-term debt, two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for stock investors.


Is there an optimal debt-equity relationship?
In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments.

A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.

Capital Ratios and Indicators

In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position.

The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt + total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt.



Testing Balance Sheet Strength

For stock investors, the balance sheet is an important consideration for investing in a company's stock because it is a reflection of what the company owns and owes. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capitalization structure.


The Cash Conversion Cycle (CCC)
The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. In addition, the CCC is equally important as measurement of a company's ability to efficiently manage two of its most important assets - accounts receivable and inventory.

Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter this cycle is, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than tying up unproductive working capital in assets.

CCC = DIO + DSO – DPO

DIO - Days Inventory Outstanding
DSO - Days Sales Outstanding
DPO - Days Payable Outstanding

There is no single optimal metric for the CCC, which is also referred to as a company's operating cycle. As a rule, a company's cash conversion cycle will be influenced heavily by the type of product or service it provides and industry characteristics.

Investors looking for investment quality in this area of a company's balance sheet need to track the CCC over an extended period of time (for example, five to 10 years), and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in inventory on hand are generally not positive investment-quality indicators.

The Fixed Asset Turnover Ratio

Property, plant and equipment (PP&E), or fixed assets, is another of the "big" numbers in a company's balance sheet. In fact, it often represents the single largest component of a company's total assets. Readers should note that the term fixed assets is the financial professional's shorthand for PP&E, although investment literature sometimes refers to a company's total non-current assets as its fixed assets.

A company's investment in fixed assets is dependent, to a large degree, on its line of business. Some businesses are more capital intensive than others. Natural resource and large capital equipment producers require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers generally have around 30-40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries.

The fixed asset turnover ratio is calculated as:

Average fixed assets can be calculated by dividing the year-end PP&E of two fiscal periods (ex. 2004 and 2005 PP&E divided by 2).

This fixed asset turnover ratio indicator, looked at over time and compared to that of competitors, gives the investor an idea of how effectively a company's management is using this large and important asset. It is a rough measure of the productivity of a company's fixed assets with respect to generating sales. The higher the number of times PP&E turns over, the better. Obviously, investors should look for consistency or increasing fixed asset turnover rates as positive balance sheet investment qualities.

The Return on Assets Ratio
Return on assets (ROA) is considered to be a profitability ratio - it shows how much a company is earning on its total assets. Nevertheless, it is worthwhile to view the ROA ratio as an indicator of asset performance.

The ROA ratio (percentage) is calculated as:

Average total assets can be calculated by dividing the year-end total assets of two fiscal periods (ex 2004 and 2005 PP&E divided by 2).

The ROA ratio is expressed as a percentage return by comparing net income, the bottom line of the statement of income, to average total assets. A high percentage return implies well-managed assets. Here again, the ROA ratio is best employed as a comparative analysis of a company’s own historical performance and with companies in a similar line of business.

The Impact of Intangible Assets
Numerous non-physical assets are considered intangible assets, which can essentially be categorized into three different types: intellectual property (patents, copyrights, trademarks, brand names, etc.), deferred charges (capitalized expenses), and purchased goodwill (the cost of an investment in excess of book value).

Unfortunately, there is little uniformity in balance sheet presentations for intangible assets or the terminology used in the account captions. Often, intangibles are buried in other assets and only disclosed in a note to the financials.

The dollars involved in intellectual property and deferred charges are generally not material and, in most cases, don't warrant much analytical scrutiny. However, investors are encouraged to take a careful look at the amount of purchased goodwill in a company's balance sheet because some investment professionals are uncomfortable with a large amount of purchased goodwill. Today's acquired "beauty" sometimes turns into tomorrow's "beast". Only time will tell if the acquisition price paid by the acquiring company was really fair value. The return to the acquiring company will be realized only if, in the future, it is able to turn the acquisition into positive earnings.

Conservative analysts will deduct the amount of purchased goodwill from shareholders equity to arrive at a company's tangible net worth. In the absence of any precise analytical measurement to make a judgment on the impact of this deduction, try using plain common sense. If the deduction of purchased goodwill has a material negative impact on a company's equity position, it should be a matter of concern to investors. For example, a moderately leveraged balance sheet might look really ugly if its debt liabilities are seriously in excess of its tangible equity position.

Companies acquire other companies, so purchased goodwill is a fact of life in financial accounting. Investors, however, need to look carefully at a relatively large amount of purchased goodwill in a balance sheet. The impact of this account on the investment quality of a balance sheet needs to be judged in terms of its comparative size to shareholders' equity and the company's success rate with acquisitions. This truly is a judgment call, but one that needs to be considered thoughtfully.

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