Three financial metrics that you need to know

When I first started out with investing I didn’t know anything at all about investing and financial metrics.

Blue figure of bank with text about financial metrics.

The company that I was working for was a startup in a highly specific scientific field and of course I bought into the idea that we would all become rich eventually.

Unfortunately that did not pan out the way that I had planned and I lost money together with all the others.

So instead I began to research the best way to invest my money. It turned out that the approach that I had taken was akin to betting at the lottery.

Sometimes you win, but because the odds are stacked against you, in the end you will lose your money.

So it was clear that I needed to do something different.

My research led me to the classic value investors, but they were embroiled in a language that I did not understand.

I mean what do words like “working capital”, “free cash flow” and “net income” really mean?

What that meant was that I needed to go deeper in my research to really understand the concepts and terms involved in value investing.

So in this series of articles I will try to elucidate what some of the “value” terms really mean.

I will begin with the metrics mentioned above and I start off with working capital:

Working capital

The first thing that you need to do is to download your favorite company’s annual or quarterly report.

Either you can find this on the company’s web page or you can download it from EDGAR website (because all companies trading om the US stock exchange are forced to release their numbers publicly).

If you then go to the Balance Sheet of your favorite enterprise, you will find the assets and the liabilities.

These are then further divided into current assets and liabilities and total assets and liabilities (Figure 1).

Hypothetical Balance Sheet with current assets and liabilities and total assets and liabilities.

Figure 1. Hypothetical Balance Sheet with current assets and liabilities and total assets and liabilities.

The current proportion of the assets is what the company has in cash or can turn into cash within short notice.

The current proportion of the liabilities is the debt that the company needs to pay within a year.

The working capital is then calculated as current assets minus current liabilities.

What it means is how much money the company has to pay its bills during the year.

If this number is negative then the company somehow needs to raise cash during the year.

That can happen either by an Initial Public Offering (IPO) or by a direct investment from external sources.

You can also calculate a working capital ratio as current assets divided by current liabilities.

If this ratio is greater than 1 then the company has enough money to cover its bills.

If it is less than 1 then they need external financing.

A negative working capital, or a ratio below 1, is most of time a warning signal for a conservative investor.

Free cash flow

The second metric that you hear a lot in the financial press is the free cash flow.

So what is the FCF and why is it important?

To calculate the FCF you will need to go to the cash flow statement of the company that you are interested in.

You will see that it is divided into three different sections:

  1. Operational cash flow
  2. Cash flow from investing activities
  3. Cash flow financing activities

The FCF is then defined as the operational cash flow minus capital expenditures (CAPEX).

So what is CAPEX and where can I find it?

Under the Cash flow from investing activities you will find a section called “Additions to operating assets and facilities” (or something equivalent).

This is CAPEX and it represents the cash that the company pays out in order to maintain or expand its productive assets.

So in effect, the free cash flow is the cash the company generates after paying its bills on its productive assets.

The FCF is the cash that the company can use for paying dividends or share buybacks. In other words measures to increase shareholder value.

If the Free Cash Flow is negative the company does not generate enough money to pay its dividends. It therefore needs to borrow the money from someplace else in order to stay afloat.

Net income

What is net income and how is it calculated?

To find the net income you need to go to the Income statement in the annual report.

There you will different item like the Total revenue which is the total amount of sales that the company generated for the period.

The next thing that you will find is the Total expenses. These are deducted form the Total revenues in order to get the Net income.

Thus the Net income is a measure for the profit the company has made during the reporting period.

What does the ratio between the Net income and Total revenue tell me?

It’s a measure of the profitability. For a manufacturing company, the ratio between the two is usually an indication of its comparative strength and weakness.

I would consider a figure above 5 percent satisfactory.

What is then the Return on equity, what does it say and how is it calculated?

This is a measure of the return on the invested capital or in other words the company’s profitability.

The number is calculated by taking the Net income and dividing by the Book value.

The Book value is turn calculated by taking the Total assets minus Intangible fixed assets (goodwill and patents) and Total liabilities.

A high Return on equity usually goes along with a high annual growth rate in earnings per share.

Conclusion:

Today I’ve been looking at the working capital and tried to give a definition of what it means.

A positive working capital tells the investor that the company can pay its bills for the year while a negative working capital says that it cannot pay its bills.

I’ve also gone through Free cash flow which is the money generated by the company when all bills on productive assets have been paid.

I have also talked about Net income to Total revenue and what it means for the profitability of the company.

 

 

 

 

 

 

 

 

 

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