Analyzing Firms

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.

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.

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.

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.

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.

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.