SINGAPORE (Jan 10): The starting point of investing is to identify stocks with sustainable dividends and a steady growth outlook.
This allows the investor to get “paid for waiting” as the company grows its earnings. Earnings growth enables companies to stash away “cash” in the form of retained earnings which eventually add to the company’s valuations.
Sounds easy enough but how do investors go about doing this? Study the financial statements.
The three main financial statements of a company are its income statement, balance sheet, and cash flow statement. These three statements are interrelated, and collectively reflect a company’s profitability, financial position and cash movements. The information in these statements is used for ratios which are important valuation metrics.
This week, we are looking at the income statement and balance sheet. Next week, we will look at the cash flow statement.
The income statement
The income statement is also known as the profit and loss statement because it reflects the profitability and performance of a company across a period of time, usually three months, six months, nine months and a year. The income statement shows the revenue earned and expenses incurred during a given period.
Not all income statements would have the same components because it depends on the nature of the business and what transpired during the given period.
Each line on the income statement is important for financial analysis and evaluation of the company. When looking at the income statement, it is important to pay attention to the notes, which will provide additional details on the reported figures.
The income statement typically starts with the revenue (top line), followed by the deduction of expenses and addition of other income to arrive at net profits or earnings (bottom line).
From the income statement, the following items can be derived, which is useful for financial analysis of a company: Gross Profits, Operating Profits, Net Profits, Ebitda, Ebit, and EBT. Most of these figures are readily available on the website of the Singapore Exchange.
Margins reflect competitive advantage
Gross profit, operating profit and net profit can be converted into ratios such as gross margins, operating margins and net income margins. Margins are important because they represent a company’s competitive advantage. Legendary investor Warren Buffett called competitive advantage a “moat”.
Gross margins represent how much of a company’s revenue is left after deducting direct costs related to the production of its goods and services.
Gross Margins = Gross Profits ÷ Revenue
Operating margins give an indication of the residual revenue after deducting variable costs such as wages and raw materials.
Operating Margins = Operating Profits ÷ Revenue
Net Income margins reflect how much profit a company generates for each dollar of sale after deducting all expenses.
Net Income Margins = Net Income ÷ Revenue
Margins are a useful comparison against peers within the same industry and against the industry’s average or benchmark.
Ideally, if a company has higher margins than the benchmark, it is a favourable indicator. Another way of incorporating margins into financial analysis is to study the historical trend of margins, usually from quarter to quarter over the past few years. If margins are improving over time, it is a good sign that the business is doing well.
Another ratio that can be derived from the income statement is the interest coverage ratio which assesses the solvency of the company. Interest coverage ratio indicates the company’s capacity and ability to meet interest payments on its debt.
Ideally, this ratio should be more than two times, and its formula is based on Ebitda to finance expenses or Ebit to finance expenses, depending on the nature of the business. The higher the value for this ratio, the greater the company’s ability to remain as a going concern.
The balance sheet
The balance sheet is also known as the statement of financial position because it indicates the financial health of a company at a point in time. The balance sheet shows the assets (what the company owns) and liabilities (what the company owes) of the company; along with its capital structure; comprising either debt, equity or a combination of both. The important equation to note is:
Assets – Liabilities = Equity
Both assets and liabilities are usually divided into current and non-current types, where current usually represent a time period of one year or less (short term); while non-current is for a time period of more than a year (long term). For example, current assets represent assets that are expected to be converted to cash within one year; while current liabilities are liabilities expected to be settled within one year.
For financial analysis, liquidity and solvency ratios are mostly derived from the balance sheet. Liquidity ratios are used to gauge the ability for the company to pay off short-term obligations (debt) without having to raise additional capital. One of the more popular liquidity ratios is the quick ratio.
Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
The quick ratio shows the company’s ability to settle short-term liabilities with its most liquid assets excluding inventory.
The current ratio is a less conservative measure of the company’s short-term liquidity.
Current Ratio = Current Assets ÷ Current Liabilities
Singapore Telecommunications’ (SingTel) current ratio, for example, is (6,921.4/10,601.5) = 0.65 times. Ideally, both these ratios should be more than 1 times for a company to be deemed as a relatively safe investment, but can vary depending on the industry’s average. In short, higher numbers indicate better liquidity and hence a desirable investment trait, because liquidity is the ability to convert assets into cash quickly.
Watch the solvency or gearing ratios too. These ratios revolve around the amount of debt a company has:
Debt to Equity = Total Debt ÷ Total Equity
Net Debt to Equity = (Total Debt – Cash & Cash Equivalents) ÷ Total Equity
For example, SingTel’s net debt to equity, derived from items in Tables 1 and 2, is [(4,100.9+435.9+7,643.6+1,929.4−550.9)/27,548.9] = 49.2% .
For REITs,
Gearing ratio = Net Debt ÷ Total Assets
Generally, a company which is financed with more than 50% debt needs to be carefully monitored by investors; and even more so if it is over 100%. For example, a company with a net debt to equity of over 100% has more debt than equity.
Another type of ratio that can be derived from the balance sheet is the efficiency ratio. Efficiency ratios reflect how well a company is utilising its assets.
The Inventory Turnover Ratio shows how fast a company’s inventory is being sold in a period.
Inventory Turnover Ratio = Cost of Goods Sold ÷ Average of Current and Previous Years’ Inventory
The Receivables Turnover Ratio shows how fast a company’s customers settle their receivables within a period.
Receivables Turnover Ratio = Revenue ÷ Average of Current and Previous Years’ Receivables
The Payables Turnover Ratio shows how fast the company is able to settle its payables with its creditors.
Payables Turnover Ratio = Cost of Goods Sold ÷ Average of Current and Previous Years’ Payables
These ratios collectively indicate the demand for the company’s inventory, the quality of its customers and credit terms with its suppliers and creditors.
It is important to note that although a higher figure is preferred for all three efficiency ratios, it depends on the type of industry the company is in; ideally the company should be doing better than the industry average to be favourable as an investment.
