· Moat
· Management
Analyzing the financials of a business is necessary to find how cash runs through a business and measure how a company's assets compare to its debt.
In this article I'll go over what to analyze in each of the two main financial statements, and how to find cash flow.
Financials
Income Statement
Margins
High margins are one of the best ways to judge how efficient a company is. They also help show who has the better competitive advantage, either by a better cost system or the ability to price their goods higher.
I like to look a gross margins, operating margins (which are usually the best way to compare competitors so different tax rates don't skew the results), profit margins and cash flow margins.
Expenses
After looking at margins it is a necessity that one use a percentage analysis, this is done by dividing each expense by revenue to find where revenue is spent before it falls down to income.
It's also beneficial to find how expenses may change. Companies like Overstock have artificially low income numbers because their variable expenses can be leveraged in the future to allow more money to fall to the bottom line.
Growth
Growth fuels investor's returns. If a company can grow its earnings in double digits for multiple years it is likely to be undervalued.
I first like to focus on revenue growth, if a company will be growing income in the future based on more products sales, or if it grows income by reducing expenses anticipating revenue growth will allow you to find income growth.
Also, when evaluating past growth, if you expect growth to stay at its current level, make sure the growth rate is climbing.
Balance Sheet
Cash
I like to start with the assets and cash is the first thing I check.
First, check to make sure cash is growing, and also that it is a good percent of current assets.
Other Current Assets
As before mentioned check to make sure a company isn't growing its revenue on accounts receivables, if accounts receivables are growing faster than revenue you may want to pass.
A lot of inventory can be good or bad. If the company has a lot of finished goods inventory it can mean a drop in sales is near, but if the company has a lot works-in-progress inventory it can signal more revenue growth soon.
Watch for a lot of deferred tax assets, these only last so long.
Intangibles
These can also be positive or negative. Intangibles assets can provide a competitive advantage, but it should probably not be included in any valuation.
PP&E
PP&E is hard to judge and can be good if real estate was purchased a long-time ago, but equipment and other property can erode sometimes faster than management expects.
Debt
In general I frown upon long-term debt, but in some industries it is necessary, so it is best to look for companies with little debt relative to competitors in stead of not investing in companies with debt period.
Also, as Steve mentioned, a high accounts payable balance is not always a bad thing.
Many retailers can produce excess cash amounts by managing their working capital well and extending the amount of time they have to pay suppliers to a period longer than the time it takes them to collect from customers.
Cash Flow
There a innumerable amounts of ways to measure cash flow and almost every entry can be taken out or added into income to come up with a different amount, I will only go over four kinds here, but recommend reading non-stop to learn all the ways.
The four I will go over are:
- Free Cash Flow
- Owner's Earnings
- Free Cash Flow to the Firm
- Maintenance Vs Growth CapEx
Free Cash Flow
Free cash flow is simply Operating Cash Flow minus Capital Expenditures. This is good to use for quick comparisons to other company's valuations or to income, but I would not put much stock in it as companies can add a lot of crap to what determines operating cash.
Owner's Earnings
A more clean way to find cash flow, and Warren Buffett's method, is to add back non-cash charges like deprecation and then subtract the actual expense: capital expenditures.
This method helps more than free cash flow, but it does not take into account any changes in working capital. When a company increases accounts receivables its sales go up while it does not collect the cash, conversely they may account for expenses that they have yet to pay with accounts payables.
Free Cash Flow to the Firm
To account for these working capital changes you can use this method. It's the same as owner's earning, but the change in working capital is applied.
It is important to point out that when using net income to find real cash flow, you are using relatively unpredictable items, like interest, that are not related to the operations of the company. A way to correct this is to apply the tax rate to operating income and then add back non cash charges and subtract capex and investment in working capital.
Also, companies can't grow cash flow based totally on working capital changes forever so it is important to compare free cash flow to the firm with owner's earnings.
Maintenance Vs. Growth CapEx
Capital Expenditures is the cash paid out to invest in the company. It buys PP&E and other things to help the company sustain its growth.
Some companies have huge CapEx because they are trying to fund huge growth. Some analysts say that this high CapEx number punishes the company when its maintenance (what it would take to sustain the current earnings) CapEx would be lower.
They then advocate separating maintenance CapEx from growth CapEx to find the real cash flow.
Here's my position on this: If a company needs to spend money to grow, that's cash going out the door, regardless of whether or not its funding growth the company will not need in five or ten years.
So if you're going to separate the two to apply to numbers in the future more power to you, but if you separate them and then apply it to a multiple today I believe it is the inverse of what the initial goal was, to find the actual amount of cash a company made in the year. This is because even though a company could sustain its current operations with a lower CapEx number, it has chosen to grow in stead and pretending it didn't spend that money to grow is an easy way to get mediocre returns.
Best Buy
Income Statement
Margins
Best Buy's margins are among the best in the industry. While it has a five year-average of a 25% gross margin and 4% profit margin, Circuit City has averaged 24% gross margins and less than half a percent profit margins.
Growth
Best Buy has a good history of growth. Over the past nine years it has a steady history of 17% revenue growth and 30% (though a lot less steady) income growth.
The income growth is volatile, but I believe they can grow in double digits for at least a few more years.
Balance Sheet
Cash
Best Buy's cash makes up 10% of its assets and has grown an average of 16% per year over the last nine, 19% in the last year.
Other Assets
Best Buy has inventory of almost half of its assets, though this is fine since it is a retailer and this could signal good revenue growth soon.
Debt
Best Buy's long-term and short-term debt account for only 3/4's of its cash, so it is not over-leveraged.
It does have a lot of accounts payable, but this is fine.
Cash Flow
Free Cash Flow
Best Buy has Free Cash Flow of $1 billion which is about a 6% earnings yield.
Owner's Earnings
Best Buy's Owner's earnings are $1.25 billion which is a 7% earnings yield.
Free Cash Flow to the Firm
Best Buy's FCFF is $1.7 billion which is a 9.7% earnings yield.
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