Fundamental Investing: Things to Look at When You Invest (Part 2 - Ch. 2)

What are the financial ratios needed for you to select good stocks?

Before this, we looked at a few ratios that you can use when doing your financial ratio analysis on a company. If you haven’t read that one yet, do check it out below:

Fundamental Investing: Things to Look at When You Invest (Part 2 — Ch. 1)

To summarize things, here are the steps needed when selecting stocks:

So, we are in the second step, where we’re supposed to do financial ratio analysis to see if the stock is good or not. Here is the chart of all the ratios we’ve mentioned way back:

From all of the above, we have picked only a few in the first chapter of this series, apart from a few other financial indicators. In the first chapter, we’ve looked into gross income, net income, PAT Margin, cash flow from operations, and earnings per share (EPS).

In this chapter, we’ll look into a few more. Let’s go!

How efficient the company is with investment

You’ll also want to know how well the company can grow the dollars you gave them. After all, who wants to invest in a company that can’t grow your money? This is not charity, right? To be frank, even in charity you’d want to see your money being managed wisely, what more when it comes to investing.

The indicator that you can use to gauge this is by looking at a company’s Return on Equity. We did explain how to find ROE in the hyperlink beforementioned, but you can also look for ROE online. Generally, an ROE between 10–20% is a good indicator, while 5% is bad. If it can reach up to 30%, it means that the company is really growing well. Mind you, Apple’s ROE in 2022 is 163.45%, do with that as you will.

However, the ROE must also be looked at in comparison with the company’s competitors. Sometimes a company’s ROE is low, but it’s not just the company that’s suffering, perhaps the industry is taking a hit as a whole. Whether an ROE range is good or bad may also vary depending on the sector. Some sector may fare with lower average ROE compared to the others.

Another thing that may deceive you when it comes to ROE is that ROE is calculated with average shareholders’ equity as its denominator, so if the company relies more on debt than shares issuance, the ROE may seem high, but the company is actually running high on debt and interest payments. If you want to dissect how the ROE came about, whether it’s shouldered on debts or not, we’d suggest you read our article here.

So, what conclusion can you get from looking at ROE is generally how efficiently your money is being managed which will also paint you a picture of how scalable the company will be as it moves forward, and how efficiently your money is being managed.

Debts

Most business will run on debt, but it’s not a bad thing if the debt is well-managed. How can you roughly gauge into a company’s debt is by looking at its debt-to-equity ratio. This ratio will tell you how much debt they have compared to the equities that they hold. Generally, an increasing debt-to-equity ratio will tell you that the company is acquiring more and more debt.

A company shouldering an increasing amount of debt can be a flag (not a red flag) that you will have to investigate. For example, you can compare it with their Interest Coverage Ratio which tells you how easily can the company repay its interest obligations.

If for example a company’s debt-to-equity ratio increases by 10%, but the Interest Coverage Ratio increases by 30%, you can assume that despite acquiring more debt, they’re also making substantial money so the debt wouldn’t be much of a risk, and in some cases these debts can even be to their advantage.

How well is their product selling

Especially for companies that are heavy on manufacturing, in order to see how well their sales are doing, you will have to look into its Inventory Days ratio.

The Inventory Number of Days ratio, also known as Days Inventory Outstanding, is a financial ratio that measures the average number of days it takes for a company to sell its inventory. It tells you how long a company holds onto its inventory before it is sold.

Generally, A lower ratio indicates that a company is selling its inventory more quickly, which can be a positive sign. However, you’ll also have to compare it with the value of inventory mentioned in the financial statement as well as the PAT margin ratio.

You’ll need to compare it with the two to see if the inventory is growing. For example, if the value of inventory increases, it could mean that a lot of products are left unsold, but it could also mean that the company is producing more. So, when you look at the inventory days ratio alongside the inventory value, you’ll get the real context of what is going on.

At the same time, if the inventory is growing, you’ll want to know if they’re growing well or not, right? That’s why you should compare it with the PAT margin. If the PAT margin is growing alongside the inventory, it means that the company is really growing its sales.

Let’s look at Apple’s inventory, for example, we can see that its inventory size is declining from the year 2021 to 2022.

To see why Apple’s inventory size is declining, we have to look into its PAT margin and its inventory days ratio. Its PAT margin is as follows:

It shows that Apple’s PAT margin is slowing down, which could indicate that Apple is producing and selling less. As for its inventory days, here’s how it goes:

Now, from the two indicators that we crossed-refer with, we can roughly tell that Apple’s inventory size is decreasing as their sales are going slower and they take more time to clear their inventory. That’s why they correspond accordingly which is to slow down their production, hence the shrinking inventory size.

However, this is just a general hypothesis on what’s going on. You’ll have to look at other indicators as well to see how well Apple is doing, and make sure to compare Apple’s performance with its competitors to see if it’s just Apple or if the whole industry is slowing down.

Mind you, we only use the data from 2 years only for education purposes. When you’re doing it in real life, look into at least 5 years of data (depending on your investment time frame) to get a better context on the company’s performance.

Sales vs Receivables

When looking at how well a company is pushing for its sales, you must also look into its sales in comparison to its receivables. Receivables here refer to the amount that the company is yet to get, for example, if its customers are purchasing via credit method.

Generally, a company which push its sales by encouraging its customers to pay in credit may raise concerns about the marketability of its products. This would usually give out the sentiment that the product is not priced well enough that customers would only want to buy it through credit. However, this may vary depending on the kind of products offered. If we’re talking about car manufacturers, it’s most likely that people would buy it through credit — not many can afford to buy in cash.

Let’s take a look at Apple’s receivables:

The way we’re going to do it is look at the percentage of receivables from its net income and see if it’s increasing or otherwise.

From what we can see above, Apple is not struggling to sell its products by encouraging people to buy it via credit, on the contrary, they’re receiving a lot of bookings for its products and they’re trying to keep up with it, especially in 2021. It’s either the demand is high, or the production is slow, but looking at its income, etc. we can pinpoint it to a surge in demand.

Bottom line

In this chapter, you’ll figure out how to look at a company’s efficiency with your money, its debt status, how quickly are they selling its products, and how they drive its sales. Do take note of these few things:

Use data from a few years (we’d suggest a minimum of 5).
Corroborate your hypothesis in one indicator by looking at other indicators.
Get the full picture of why the company is performing in such a way by looking at the indicators of its competitors within the same industry.

The key takeaways/market update is a series by AxeHedge, which serves as an initiative to bring compact and informative In/Visible Talks recaps/takeaways on leading brands and investment events happening around the globe.

Do keep an eye out for our posts by subscribing to our channel and social media.

None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.