Security Analysis: Financial Strength and Capital Structure
This is perhaps the most widely analysed section while selecting securities for investments. Let’s start with the basics. Suppose you were to make a choice between two companies both having the same market price and earnings per share. One has surplus cash and no debt, while the other has a large bank loan. The choice is clearly the cash rich company because the cash today is more valuable than cash tomorrow. These are the kind of factors that analysts carefully analyse while making investment choices. The above example doesn’t mean that debt is bad. In fact financial leverage can help increase the value of the company. However, a combination of less common stock and more preferred stock/debt is good only for speculation, not for long-term investing.
Here are some essential items you need to check while looking at a company’s financials.
Calculate owner’s earnings
The concept of owner’s earnings was popularized by Warren Buffet. The owner’s earnings essentially reflect how much money you would have in your wallet if you owned 100% of the business. This can be calculated using the statement of cash flows: Net Income + Amortization and Depreciation – Normal Capital Expenditures. Essentially it adjusts the accounts for items that do not really affect the cash flow of the business.
Check if the owner’s earnings have been growing consistently over the past 10 years, atleast 6-7% per year. If yes, then the company has bright growth prospects for the future.
Check company’s capital structure
From the balance sheet check how much debt the company has including preferred stock.
Check how much the long-term debt as a percentage of total capital is. The number should ideally be below 50%.
Somewhere in the notes to financial statements you will also find if the debt is taken on fixed-rate or floating-rate. Depending on your forecasts about the interest rates, this can help you project changes in future financial charges.
You should also calculate the ratio of “earnings to fixed charges.” This indicates if the company is generating atleast enough to cover up the fixed charges. For tech companies such as Amazon, earnings fell short to even cover the interest cost for many years. In such situation the company needs to earn much more to carry on or needs to borrow more money at lower cost.