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When I started investing 10 years ago, I vividly remember how confused I was when it came to analyzing the financial statements of a company. There are so many proportions out there and I wasn’t sure which ones I should use.
In the end, I just used them all for my selection and analysis, and it was confusing to look at everything.
After many years of investing, I realized that it is not necessary to use all the proportions and that some of them have overlapping uses. I am a strong believer in the Pareto principle, which means that 80 percent of the results come from 20 percent of the causes.
So, I decided to ‘Marie Kondo’ my financial evaluation template and zoom in on the ratios that are important for best results. I put great weight on these four proportions. By using them, you can spot good companies and filter out bad ones.
1. Gross profit margin
The gross profit margin shows the amount of gross profit as a percentage of revenue.
Companies that have a low gross profit margin generally have trouble achieving healthy net profits because they have no margin for error. Therefore, companies with low gross profit margins tend to have low net profit margins as well.
Having a high gross margin gives companies better opportunities to make wise capital allocation decisions than companies with low gross profit margins. As a general rule of thumb, I like companies that have at least 20 percent gross margin.
2. Return on capital
Return on equity (ROE) measures how effective the business is at generating profit for every dollar it has in equity. When comparing ROE within an industry, a company that is capable of consistently generating a higher ROE tends to have the competitive advantage.
A declining ROE generally means poor capital allocation decisions followed by the possibility of losing your position in the market. I like to look for companies with an ROE of at least 10% or more.
3. Quality of income
In the business world, it is normal for a business to provide credit terms, which means that you are not paid immediately after providing a product or service. The credit term can be any number of days.
For example, if a company grants a credit term of 30 days, it will provide its service and then collect the money from its customers up to 30 days later. There will be cases in which the company cannot or takes a long time to collect the credit.
This results in low cash flow, although the gain is already reflected in the income statement. Therefore, I always like to use value for money.
The income quality index measures every dollar of operating cash flow generated for every dollar of net income. Good companies usually have a ratio greater than 1.0 which means that the quality of the income is high.
For example, if the business has a constant ROE of 15 percent, and yet its quality index of revenue is consistently below 1.0, then its ROE is of lower quality because the revenue may just be a profit on paper. and the company has problems. collect your payments.
Cash flow is always king when it comes to running a business, it doesn’t make sense to record high profits with low cash flows.
4. Debt to equity
The last thing you want to do is invest in a company that has a serious debt problem that could cause large investment losses when the company goes bankrupt or is diluted by raising equity funds. Therefore, the debt-to-equity assessment helps you filter out companies that may have too much debt.
The index measures the amount of debt the company has compared to its equity. Having some debt is not necessarily a bad thing, what matters is the way the company manages the amount of debt.
As a general guideline, companies with a debt-to-equity ratio of less than 0.5 tend to have manageable debt levels.
The fifth perspective
Of course, these four proportions do not paint the whole picture; you still need to assess a company’s business model, growth drivers, and risk factors, among other things. Therefore, you should never invest in a stock based solely on these four ratios.
However, I have found that these four ratios have worked especially well for me when it comes to researching investment ideas and finding great companies to begin my research. So go ahead and use them and see what investment ideas you can come up with for yourself.
This article was first published in The Fifth person. All content is displayed for general information purposes only and does not constitute professional financial advice.
