I remember how confused I was about analysing financial statements when I first started investing ten years ago. There are many ratios available and I wasn’t sure which one I should use. It was overwhelming looking at all the options, so I decided to use all for my analysis and screening.
After years of investing, it dawned on me that not all ratios are necessary and that some ratios can be used in a variety of ways. Pareto is a principle that 80% of results come from 20% causes.
I made the decision to “Marie Kondo” my financial screening tool and focus on the important ratios to get better results. These four ratios were the most important to me. These ratios can be used to identify good companies and filter out bad ones.
1. Gross profit margin
Gross profit margin is the percentage of revenue that represents gross profits. Low gross profit margins are more likely to have low net profits. This is because there is no room for error. Companies with low gross profits margins also tend to have lower net profit margins.
Companies with a high gross margin have better chances to make smart decisions about capital allocation than those with low gross profits margins. I prefer companies with a minimum of 20% gross margin.
2. Return on equity
The company’s return on equity (ROE), measures its ability to generate profits for every dollar of equity. A company with a consistent higher ROE is more competitive than a company that generates a lower ROE in an industry. An ailing ROE can indicate poor capital allocation decisions that could lead to a loss of market position. I prefer companies that have a ROE of 10% or higher.
3. Quality of income
Credit terms are a common practice in the business world. This means that companies do not receive payment immediately after they have provided a product or service. Credit terms can last for as long as 30 days.
If a company offers a credit term of 30 day, they will deliver their service and then collect money from customers up to 30 business days later. Sometimes the company may not be able to or take a long time collecting the credit. Even though the income statement already shows the profit, this can lead to low cash flow. Therefore, I like to always use the quality-of income ratio.
The quality-of income ratio is the sum of every dollar of operating cashflow generated for every dollar earned in net income. A high ratio indicates that the quality income is good.
If a company’s ROE is 15% but its quality-of income ratio is consistently lower than 1.0, it is likely that its ROE is not as good. This is because the income is a paper gain and the company is having trouble recovering their payments. When it comes to managing a business, cash flow is paramount. It’s not worth recording high profits while having low cash flows.
4. Debt to equity
You don’t want to invest in a company with a significant debt problem. This could lead to heavy investment losses if the company goes bankrupt, or is diluted by equity fund raising. You can filter out companies with too high debt by using the debt-to equity ratio.
This ratio shows how much debt a company has relative to its equity. It is not necessarily a bad thing to have some debt. What matters is how the company manages that debt. Companies with a debt-to-equity ratio less than 0.5 typically have manageable levels of debt.
The fifth perspective
Of course, these four ratios don’t paint the entire picture; you still need to evaluate a company’s business model, growth drivers, and risk factors among other things. These four ratios are not enough to determine whether you should invest in a stock.
These four ratios work especially well for me in screening for investment ideas. They also help me find great companies to do my research on. These four ratios are easy to use, so get out there and start exploring investment ideas.