Financial Statements: 5 Most Important Ratios and Numbers
"I spent more time looking at balance sheets than I do income statements." - Warren Buffett
As this substack builds our audience on X / Twitter, Telegram (and substack of course), readers have requested that we dial down the difficulty and complexity of the posts. Hence, this is one of those back-to-basics post.
We will go through the basics of financial statements briefly and quickly focus on the meat → the 5 most important financial ratios and numbers! Leveraging A.I., I have asked Gemini Pro to generate a quick preamble (to save time) and it came back with a link to a wonderful video of a beautiful Singaporean accountant teaching the basics below. Talk about human / A.I. cooperation! I did have to make some quick edits to Gemini’s output though. As such, perhaps ChatGPT is still better.
Financial statements are a company's report card, describing its financial health and performance at the end of the reporting period.
The Balance Sheet is a snapshot of what a company owns (assets), owes (liabilities), and what's left for the owners (equity) at a specific point in time.
The Income Statement (or Profit and Loss Statement) shows how much money a company made and spent over a period, ultimately revealing if it was profitable or not.
Finally, the Cash Flow Statement tracks the actual movement of money in and out of the company's bank accounts over a period of time.
To learn more about financial statements, please watch Beginners Guide to Financial Statements Explained.
A long time ago, in another blogosphere far, far away, we have also written extensively on financial statement analysis. Interested readers can read them below (WARNING: it’s very, very, very dry):
Financial Statements (18 posts) https://8percentpa.blogspot.com/search/label/Financial%20Statement%20Analysis
Financial Ratios (19 posts) https://8percentpa.blogspot.com/search/label/Financial%20Ratios
But today, we are not going to go through these boring stuff that can put owls to sleep. We shall discuss the five most important metrics that investors should look at. We will also delve a bit more into the mindset of activists, who will also likely look at these numbers and we intend to follow up with another post on what else activists track.
Here they are in no particular order.
1. Free Cashflow or FCF (Cashflow Statement)
2. Operating Margins or OPM (Income Statement)
3. ROA and ROE (Income Statement and Balance Sheet)
4. Net Debt (Balance Sheet)
5. Increase in Book Value (Balance Sheet)1. Free Cashflow (Cashflow Statement)
We have discussed a lot about Free Cashflow on this substack. Why is it so important? That’s because it is the new Earnings Per Share or EPS which used to be the single most important financial KPI. Like numerical sales targets for salespersons or number of views for Youtubers.
Since humans invented accounting, company executives have had many decades of financial reporting experience and learnt all the tricks to generate whatever EPS they required. Financial sleuths wouldn’t be able to catch Enron just analyzing its income statement and its EPS. You can keep reporting strong EPS for years and years using creative accounting. Most of the time, it’s not even illegal.
Cashflows are harder to manipulate and hence financial analysts have recently focused more on Free Cashflow or FCF. Analysts then used that to calculate FCF yield and Enterprise Value over FCF. EPS is still religiously tracked, but looking at FCF has become imperative. Let’s look at the formula:
Free Cashflow (FCF) = Operating Cashflow - Capital Expenditure (Capex)
FCF starts with operating cashflow earned and we deduct Capital Expenditure or Capex. Capex is the investments needed to keep the business going, like buying new machinery, software etc.
The leftover cash is truly "free" for the company to use for things like paying down debt, issuing dividends, buying back shares, or pursuing new opportunities. Activists tend to look at this a lot because it often take years to successfully engage their investee companies. If the business is not sound and cannot generate FCF, then it might be difficult for them to invest.
Therefore consistent or even better, growing FCF is a sign that the business model is robust, economic moat of the business is likely strong. It also signals that management at least understands and tries to manage cashflow well.
2. Operating Margins
Operating margin is simply the following:
Operating Margin (OPM) = Revenue - Cost of Good Sold (COGS) - Sales, General & Administrative Expenses (SG&A)
This is a straightforward, well understood financial ratio. Essentially, it is revenue minus cost. It’s one of first thing one should look at on the Income or P&L Statement. Although high OPM is preferred, low margins doesn’t mean the business is bad. Costco (COST US), the membership based US retail giant, has one of the lowest OPM but it’s one of the best businesses ever conceived (OPM while low at 3+%, is very consistent though).
This is an important ratio for activists when they look at companies. They target companies that could inherently generate high margins but are not doing so. This means that they could go in, change management, improve margins and reap the rewards!
Next, we look at returns!
3. ROAs and ROEs
These are perhaps the most important financial ratios for any investors to understand because they represent the return you get intrinsically for the money put in. Here are the formulas:
Return on Asset (ROA) = Net Income / Total Assets *
Return on Equity (ROE) = Net Income / Total Equity
OR
Return on Equity (ROE) = Earnings Per Share (EPS) / Book Value Per Share (BVPS) **
* / represents division, so ROA is Net Income divided by Asset
** EPS = Net Income / No. of shares and BVPS = Equity / No. of shares
Let’s start with ROE. This is such an important number that I believe most readers should have heard of it, at least peripherally. Investors put equity into companies they invest in. Return on Equity or ROE then tells investors how much net profit a company generates for every dollar of shareholder money invested in it.
Imagine we start a business putting in equity of $10,000. If the ROE is 20%, it means that, at the end of the year, the we should get back $2,000. That represents a wonderful business and that’s what ROE means. The following chart shows how Costco is more than a wonderful business with ROE at c.30%!
Before we describe ROA (vs ROE), we need to introduce the equation that is the foundation of accounting and the reason why the balance sheet is called the balance sheet: assets must be balanced by liabilities and equity. This is the equation:
Total Assets = Total Liabilities + Shareholders’ Equity
For our purpose here, it suffice to know that a company's total assets (everything it owns) will be greater than its equity (what the owners have put in). Total assets also include anything funded by debt (liabilities).
ROA then shows how efficiently the entire business, using all its resources (both owner's money and borrowed money), generates profit. It gives us a broader view of management's effectiveness in utilizing all the company's assets to create earnings.
Again, looking at Costco, we can see that it’s ROA has grown from 7% to 10% over the years and that is AMAZING for a USD400+bn dollar company. Similar to operating margins, activist will look at companies that can improve their ROEs.
4. Net Debt
This 4th datapoint is what activists look at the most. First, let’s look at the formula:
Net Debt = (Short Term Debt + Long Term Debt) - Cash
When net debt is positive, it means the company has debt, which is usually not what activists are looking at. Activists want this number to be negative. What this means is that the company has no debt and is piling up cash. In Japan today, some companies have so much cash (and sometimes other hidden assets) that the total amount is bigger than its market cap.
Theoretically, this means you could be paying $100 for the company and receive $120! Japan is full of these crazy listed companies, with share price so cheap that market cap could be less than the cash on its balance sheet. Activists love these situations. That’s their edge, they go in to get companies to pay out to shareholders this excess cash.
5. Increase In Book Value
We alluded to this term Book Value a couple of times. This is also known as shareholders’ equity or total equity or net asset value or simply book or equity. Yes, it has many names. It is the accounting value of the company and what Warren Buffett looked at the most and how he used to see it as his own KPI (he recently changed it to market value because Berkshire has gotten too big to keep compounding its book value).
Again we use Costco to illustrate why increase in book value is important. Share prices move based on human emotions but book value records what actually transpired. The company generated revenue and after deducting costs, it retained net profits, this is added back to the book. This is the accounting value of the firm. Great companies compound book values. Hence Warren Buffett measured himself on how he compounded Berkshire’s book value in the early days.
Costco’s book value growth above illustrates this point well. Its Book Value per Share was $27.4 in 2016, it has grown to c.$60 today. In terms of Shareholders’ Equity (a.k.a book value), it was USD12.3bn in 2016 and is c.USD24bn today. Of course, everyone knows Costco is great company, hence share price has well reflected this and its share price is >$900 or c.15x its book value.
Activists are usually interested when the share price is below the firm’s book value per share. If the target has shown the ability to increase its book value, then that’s a bonus. Similar to cash extraction, they will find ways to get companies to close the gap between the share price and the book value.
Dividends
While not in the top five most important datapoints, dividends are ultimately what investors get. One of the first things that activist investors ask for is an increase in dividends. Growth companies are excused from paying dividends because they need all the capital to grow. But activist stocks are usually past that stage and as small investors following activists, it is also important to look at companies that would be paying dividends. If not, our capital could be locked up with zero returns for years.
In the next post, we'll explore the additional ratios and datapoints of focus for activists.
Huat Ah!
This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.