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Analyzing Firms

Liquidity, Profitability, Leverage, Growth

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Analyzing Firms Summary

The analysis of firms can be divided into specific areas of specialization. By analyzing each area, you can slowly reveal the firm’s ability to provide an adequate long-term return. After determining which companies are best to purchase over long terms via analysis, valuation and risk versus return can be estimated for investment instruments issued by a firm. Companies should be judged on their financial status and the position that management style and strategy places the company in.

You can test a firm’s financial status by using the data found on the financial statements to test financial ratios. Why should you use ratios when the financial statements show the numbers already? Ratios will reveal to information that raw numbers do not reveal. Their results can indicate the viability of the firm compared with other firms in the same industry. They’re also useful for comparing the same firm at a different period in time. You should view ratios as a great way to display the company’s overall performance only in comparison. Ratios are very worthless in a vacuum. A single year’s ratios for a single company will tell you almost nothing.

The primary power of ratios is their usage in revealing trends and changes over time, telling you history that raw numbers often don’t. If the ratio numbers are trending in favorable directions, and doing so in accelerating faster than its market price, it can be a great sign to buy. If they’re decelerating or heading towards negative directions, it can be an early sign to steer clear. The ratios can also be compared to other firms. They are especially useful when compared against other competitors or the average in the industry. If the firm behind the investment has significantly unfavorable ratios compared to other competitors or a specific competitor, determine the cause of the problem or avoid the company entirely.

Analyzing Firms

Major Economic Analysis

Economic Summaries
Statistical Currency Projections
Large Speculator Sentiment
Technical Signals Lists

American Equity Markets

Economic Performance Index
US Dollar Projections
Market Sentiment Tracking
Sector Strength Tracking
Consensus Estimate Rankings
Fundamental Firm Analysis

Liquidity Ratios

Liquidity measures a company’s ability to survive short term. This measures a firm’s ability to pay its short-term or current liability requirements. Any firm who cannot pay these requirements is dead in the short term unless it quickly makes arrangements to pay its bills. The larger a number of current assets, especially cash, in relation to current liabilities, the safer a company is. This should be the starting point for analyzing a company. If a business can’t pay short-term debts, you should find a new firm to invest in.

Liquidity Ratio Summary

Liquidity Ratio Summary

Liquidity measures a company’s ability to survive short term. This measures a firm’s ability to pay its short-term or current liability requirements. Any firm who cannot pay these requirements is dead in the short term unless it quickly makes arrangements to pay its bills. The larger the amount of current assets, especially cash, in relation to current liabilities, the safer a company is. This should be the starting point for analyzing a company. If a business can’t pay short-term debts, you should find a new firm to invest in.

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Current Ratio

Current Ratio

The current ratio is one of the quickest ways to determine if a company has liquidity. Lower current ratios increase the chance a company will not be able to clear its current liabilities. This will result in bankruptcy unless preventative measures are taken. The firm will issue shares or borrow money, either reducing the value of investments or reducing future earnings with interest costs.

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Quick Ratio

Quick Ratio

The problem with the current ratio is its inclusion of Inventory in current assets. Inventory may be qualified in its placement current assets, but it is very hard to sell at the last minute unless it’s sold at prices that destroy profit margin. Sometimes, inventory is worthless after a certain period, as it may rot, expire, or become “out of fashion” at its time of sale.

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Asset Turnover

Asset Turnover

Asset turnover displays the amount of dollars earned per asset. The higher this number is, the more efficient the company is at generating sales from their assets, which increases liquidity. The higher the ratio, the less a company may need to purchase assets, and the higher the profits they will receive from new assets purchased.

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Accounts Receivable (AR) Turnover

Accounts Receivable (AR) Turnover

Accounts Receivable Turnover displays the amount of times a company’s accounts receivable is paid in full during the year. The equation is based on credit sales, which is not always displayed. If credit sales do appear, it may be in the footnotes, or within the discussion and analysis section of the financial statement. If the firm is credit sales reliant, the turnover period needs to be equal to, or less than, the credit terms.

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Inventory Turnover

Inventory Turnover

Inventory Turnover displays the amount of times a company’s inventory is completely sold each year. Higher is generally better since it indicates they clear their inventory more often. It is best if the firm has higher inventory turnover compared to competitors. It’s best to compare this to the industry average, and other top firms.

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Accounts Payable (AP) Turnover

Accounts Payable (AP) Turnover

Accounts payable turnover displays how often a company’s accounts payable are paid in full. This turnover ratio works in reverse of other ratios. While other Turnovers Ratios increase liquidity with higher numbers, lower accounts payable turnover indicates higher liquidity. Since money is leaving the business to compensate accounts payable owed, liquidity is increased if the company can delay payment.

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Profitability Ratios

The primary point of any firm is to utilize capital invested by shareholders to generate a profit. This profit serves as the shareholders return. The best firms will generate higher average returns for their shareholders over long periods of time. It’s very important that you decipher how much money the firm sustainably earns its shareholders as a return on their investment. The absolute level earned isn’t as important as the pattern, consistency, and growth of returns.

Profitability Summary

Profitability Summary

The primary point of any firm is to utilize capital invested by shareholders to generate a profit. This profit serves as the shareholders return. The best firms will generate higher average returns for their shareholders over long periods of time. It’s very important that you decipher how much money the firm sustainably earns its shareholders as a return on their investment. The absolute level earned isn’t as important as the pattern, consistency, and growth of returns.

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Return on Assets

Return on Assets

The Return on Assets equation measures the profit generated from each dollar of assets. When Net Profit is divided by Total Assets they display Return on Assets. A Higher return on Assets is better. There are two ways to increase return on assets, by improving either of its two specific parts. They can charge higher prices for products and increase revenue, lower operating costs or costs of goods sold, or increase the actual asset turnover rate.

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Return on Total Assets

Return on Total Assets

Return on Total Assets displays the percentage profit on all of the firm’s assets. To find the Total Asset denominator, add current and fixed assets. By using earnings before interest and taxes you can determine the return before the effects of interest or taxation on the company.

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Return on Equity

Return on Equity

Return on equity is a fairly strong measure of company profitability which displays how much profit is generated for every dollar of equity invested in the company. Return on equity is simply Net Profit divided by Shareholder’s Equity. For non-financial firms, you should look for firms with Return on Equity at 10% or above. You should prefer firms with over 20% Return on Equity. Return on Equity definitely needs to be higher than the low rates of return on “guaranteed” investments such as government bonds, since companies are inherently more unstable than governments.

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Return on Invested Capital

Return on Invested Capital

Return on Invested Capital displays the firm’s ability to use capital to achieve a return. It measures the value that a firm creates. ROIC does this differently than ROA or ROE. There are multiple methods of calculating Return on Invested Capital. Each variation changes the numerator slightly, or completely. The denominator may also change.

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Profit Margin

Profit Margin

Profit Margin can be found at any point of the income statement by using “X” Profit divided by Sales Revenue. If the desire to express the number as a percentage, multiply the number by 100. You want to see high margins. This indicates low expenses and waste. A company with margins that are too high may be skimping on product or service quality.

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Gross Margin

Gross Margin

Gross Profit is the easiest profit to locate on the income statement. You find this value by subtracting Cost of Goods or Services Sold from Sales Revenue and dividing the result by Sales Revenue. You can multiply this number by 100 to express the Ratio as a percentage.

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Operating Margin

Operating Margin

Operating Margin requires subtracting all of the company or firm’s operating costs and expenses from Gross Profit. Afterwards divide Operating Profit by Sales Revenue. Multiplying this number by 100 will express the Ratio in a Percentage.

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Retained Earnings Margin

Retained Earnings Margin

The Retained Earnings Margin displays the portion of Net Earnings kept within the company for future self-financing. Select Retained Earnings from the Income Statement, and divide the figure given by sales revenue for the selected year, and multiply that number by 100.

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Free Cash Flow

Free Cash Flow

Cash flow from Operations contains a major problem: It does not display the cash that a company can use freely to improve its business. This role is handled by Free Cash Flow. While a large portion of Cash Flow from Operations is absorbed by maintaining and expanding the long-term assets of the company, Free Cash Flow does not have to be used to increase or expand those assets.

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Earnings per Share

Earnings per Share

“Earnings per Share” is a measure of the profitability of a firm or company. EPS is simply net income divided by the amount of common shares outstanding, released, or issued. Since it’s divided by the amount of shares issued, it is easily changed and usually is not constant year over year. It’s also meaningless without looking at several other factors in the stock, including cash flow.

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Retained Profit per Share

Retained Profit per Share

Retained Profit per Share is the portions of Earnings per Share that is kept as Retained Earnings. You can see the amount of the company’s earnings per share that is applied to self-financing by taking the Retained Earnings a company earns and dividing it on a per share basis. You can directly compare Retained Earnings per Share with Dividends per Share. The desire for either depends on your preference for return types.

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Leverage Ratios

When analyzing a company, it’s extremely important to measure the amount of debt and the cost of capital. High debt equates to high-interest payments. This is a fixed cost which reduces the amount of profit made during upswings in the company’s business cycle and increases losses during downswings. While debt can be used to boost growth and business expansions, you should be wary of companies with too much debt since fixed costs deflate company profits long term. You need to look for low amounts of debt in comparison to their total capitalization, specifically under twenty percent. You can also use the weighted average cost of capital to estimate the cost of the firm’s financing, including the cost of the firm’s long-term debt.

Debt to Equity

Debt to Equity

The debt to equity ratio measures the proportion that assets are funded by debt or by equity investments, or shareholder’s funds. This measure can indicate future problems with a company’s stability, and solvency. Debt allows firms to boost the asset base without diluting shareholder control or revenues. The return on assets increase generates profit, the debt generates interest costs. If the return on assets exceeds interest based profit from debt financing will exceed the interest cost.

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Financial Leverage Ratio

Financial Leverage Ratio

This ratio compares assets with equity and is a modification of the Debt to Equity Ratio. If assets are equal to equity, the ratio has an output of one, which is the lowest it can go. This means the company is paying for all of its assets with shareholder investments and has no debt. If the ratio is higher than one, this means that the firm has more assets than equity.

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Interest Coverage

Interest Coverage

The interest coverage is the total amount of times a company or firm could pay its interest expense with its earnings. The higher this number is, the farther the company is from defaulting on debts. Interest Coverage will be higher with the firm’s debt, and it will be harder for a company to make its interest payments.

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Weighted Average Cost of Capital

Weighted Average Cost of Capital

The Weighted Average Cost of Capital is the interest rate of all financing that a company has acquired after it has been weighted and averaged. This benchmark sets the base rate of return for all projects that a company interacts with and is involved in. If a company is developing a project, campaign, or product, the results of the production must exceed the result of the WACC or the company is destroying value, since the capital it is using for the project costs more than it is returning.

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Dividend Cover

Dividend Cover

The Dividend Cover displays the amount of times Earnings per Share exceeds Dividends per Share. Generally, you want Earnings per Share to be triple of Dividends per Share. The higher this number is the safer for the company. A higher Dividend Cover also means the firm is focusing more on retained earnings and reinvestment than it is on paying dividends.

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Sustainable Growth Rate

Sustainable Growth Rate

A firm’s sustainable growth rate (SGR) is its maximum potential growth without the need for additional debt-based financing. If a firm chooses to exceed this growth rate they will need to acquire more financing. Their risk increases if they seek additional leverage, due to interest payments and potential loss of collateral or bankruptcy in the case of default.

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Management

A firm’s managers determine the course of its failure and success over long periods of time. These people will ultimately determine the fate of investments in a business, irrelevant of whether it’s a startup or a blue chip firm ran for generations. Firms should be run in the long term best interest of several groups, including its stockholders or bondholders. As an investor or a credit lender, you need to know how the company is run by its management. In the long run an investment earns a return based on the choices, character, honesty, and responsibility of its management.

Management Skill and Performance

Management Skill and Performance

A firm’s managers determine the course of its failure and success over long periods of time. These people will ultimately determine the fate of investments in a business, irrelevant of whether it’s a startup or a blue chip firm ran for generations. Firms should be run in the long term best interest of several groups, including its stockholders or bondholders. As an investor or a credit lender, you need to know how the company is run by its management. In the long run, an investment earns a return based on the choices, character, honesty, and responsibility of its management.

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Conference Calls

Conference Calls

Conference calls are the primary point of communication between investors and executives who run the company. They occur every quarter and even if investors cannot hear the live conversation (or gain access to it). they are usually recorded for later listening and potentially download. You can contact a firm’s investment relations department to retrieve them if not easily accessible via website. Questions are typically asked by large investors or financial analysts assigned to the firm’s coverage by Wall Street or Institutional Investors, and most private investors can only listen. However, this is better than receiving news later from a newspaper, as tone, word selection, and confidence in delivery can potentially reveal soft spots in the firm.

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Quantify Greed

Quantify Greed

One of the biggest problems with management is greed. Many managers run companies and firms in order to generate a return on investment. However, many unfortunately run firms to generate returns for themselves at the expense of investors and creditors. One of the biggest character trait flaws of management, greed, can be the largest indicator for distrust. Does the management of the firm run its business to generate return or as a personal ATM for a jet set lifestyle?

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Management Qualities

Management Qualities

There are traits and attributes which indicate a good management team in advance. In tandem, these are very hard to find. However, these traits are always left behind by their actions. They are reflected on the financial statements, print, and news media. They will be stated amongst former workers, especially middle and upper management which dealt closely with them. Finding a team which displays the qualities below is imperative to having a good investment return.

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Firm Strategy

The strategy created by a management team determines whether or not the firm will succeed. In order to determine whether or not a firm can or will be successful in the long term you must determine the firm’s long term strategy. Does this firm have an advantage over competition? What is this firm’s edge? What attracts consumers to this firm over the other firms? Why do consumers actually purchase this firm’s products?

The firm’s strategy over the long term is a key determining factor to how well the firm will produce returns. It should always be reviewed in depth before investment.

Have Better Products or Services

Better Products or Services

Firms often pivot their strategy around building a stronger offering. They build their success on the interrelation of quality, price, and features. This separates them from other companies that offer products with less durability, adaptability, usages, or duration. People are willing to purchase their product or service offering simply because of the quality. It is not enough to create higher quality; it must be done at equal profit margins or greater margins than others at the same price range.

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Make Your Business Hard to Leave

Make Your Business Hard to Leave

A great way to ensure that business is created for a firm in the future is by creating a real or artificial obligation for them to continue dealings with the company. They ensure that profits are made in the future. How does this occur? They simply obstruct the ability to stop comfortably doing business with the firm. This is quite common and easier than it seems.

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Create Business Moats

Create Business Moats

This strategy creates an inability for competitors to compete against a firm. By dissuading others from competition, firms have time to build, market, advertise, and earn without worry. If a firm enters the market at a later time, they will be at a distinct disadvantage compared to the established firm.

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Create a Strong Brand Name

Create a Strong Brand Name

Certain firms work hard to create a strong brand name. This usually occurs by consistently releasing high quality products or services. These products add to the reputation of the firm. After a long enough time of releasing high quality products, the firm’s reputation begins to gain trust with consumers. Once established, the trust in the brand overrides consumer’s realization of a limited amount of defects or downsides.

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Undercut Competition

Undercut Competition

A firm can force its competitors into non-existence or keep its market share high simply by being cheaper than them to purchase products/services. Undercutting, frequent sales, or fire selling results in customers being more willing to shop at another competitor. If the firm frequently offers better prices, a customer may begin to believe they have the best pricing and shop there normally.

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Growth

 Strategy is used to expand firms over the long term, and the result is financial growth. A company has to grow over time to return an investment for you. If firms grow too well, they will attract others to its marketplace, and become swamped with potential competitors. This is why a firm needs to complement its growth with a strategy to withstand competitors.

Growth is used to estimate the potential of the firm in the future. While past growth does not equate to future growth, you can still garner an idea of the growth the company may typically achieve year over year. You should be careful to check where your measurement of growth begins. Beware of measuring growth from a down year or during a recession. Measuring growth from a depressed starting point allows growth rates to look stronger than if you measured the company from an average year or an above average year. If the company has a huge gain in the selected base year, the growth may look lower than it typically would be.

Analyzing Firms

International Economic Analysis:

  • Major Currency Economic Summaries
  • Performance of Major Imports and Exports
  • Mandates of Central Banks versus Expectations
  • Performance Indexes of Major Economies
  • Economically Correlated Currency Projections
  • Large Funds Currency Sentiment Readings
  • List of Technical Indicators to Look For
  • Occasional: Foregin Exchange Technicals Markups

Analyzing Firms

American Markets Analysis:

  • Summaries of American Economic Structure
  • Performance of Major
  • Imports/Exports
  • Federal Reserve Mandate versus Expectations
  • Performance Indexes of U.S Economy
  • Economically Correlated U.S Dollar Projections
  • Large Trading Fund Index Sentiment Readings
  • Market Wide Earnings Versus Valuations
  • Fundamental Ranking of U.S Business Sectors
  • Best and Worst Future Consensus Estimates
  • Occasional: Firm Fundamental Strength Report
  • List of Technicals to Look for While Trading

Analyzing Firms

Brokerages, Insurance Firms,
Financial & Trading Software.

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