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How to Understand Company Financials

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At Robur, we highlight the importance of making equity investment decisions based on the trends that can be derived from analysing company historical financials. But of course you can‘t analyse every possible aspect, so, once you have defined your company or sector of interest, you need to define your own analytical priorities. The importance of fundamental analysis is outlined in this great article at Investopedia.

Financial statements can seem like unfamiliar terrain for those for are not accountants, analysts or financial planners. Fortunately, everyone can learn to interpret them regardless of your background. All it takes is understanding of how a business functions. We have all, I am sure, played a role in a company, either as an owner on an employee – be it sales, administration, finance, IT etc.

Now picture your department, if you worked in sales, apart from the obvious metrics like revenue what would other trends would you be looking for – net profits, margins, operating profits are items that spring to mind. If you worked in production then raw material costs would be important, if you were in accounts then levels of debt and cash on hand to pay employees would matter to you.

In layman’s term, this is how we analyse the company financials, except we are looking at all parts of the business as a whole to see how the company has been performing over the previous 5 years. We use 5 years because it helps us understand both the competitive advantages of the company, and the strength of their management. Comparing just 2 years is not enough, said company could have had a one off excellent year, or a poor one. Management may have decided to pay off long term debt or had an impairment on a long term asset that does not affect the core of their business

Analysing more than 5 years does not necessarily give a ‘better’ picture. Nowadays with globalisation, international trade and technological advances business environments change rapidly, along with senior management – so the business model 10 years ago may not be the same model you are viewing today

 

What Are The Financial Statements

Financial statements can be broken down into 3 segments, the balance sheet, the income statement and the cash flow statement

None of these segments should be considered more important than the other. They are all pieces of the puzzle that help us understand an overall view of the company and its financial strengths and weaknesses.

These financial statements can be found in the company annual report. A quick Google search of the company you are looking at + investor relations will take you through to the section of the company website you are looking for. Fortunately Robur’s individual page does this hard work for you

Be warned however, companies like to fill their annual reports with a lot of information, not all of it relevant. A typical annual report can be 100+ pages, of which only 10 may be relevant to the investor.

 

Understand Company Financials

If your main priority is dividends, then earnings and dividend growth, short and long term debt, and free cash flow considerations may make up the main focus of your attention; in other words, you look at those items that will affect the companies‘ ability to keep on paying a steady dividend.

If you are looking for capital gains, then capex (capital expenditure), leverage (the amount of long-term debt and how it is being used), and the uses made of free cash may be more important to you. Price/earnings ratios will always be useful in ensuring you don‘t unwittingly overpay for stocks.

But it is important to remember that these numbers are not the whole answer on their own. It is only when they are used in comparison both to prior year performances, and against other companies in the same sector, that they really help you make your investment decisions. Our own approach to company financials, when we are considering our personal portfolios, is based on imagining that we are executives in a large organisation, charged with assessing companies in our sector for potential acquisition, and looking at business units in our organisation as potential disposals. After all, as shareholders, that is precisely what we are doing, except that obviously we only have a tiny percentage of the businesses concerned. Different types of business need different analysis: we should not look at banks in the same way as we look at chemical companies. Capital expenditure is not a useful criterion in assessing banks, for instance, but it is a vital one for industrial companies.

Singapore has an important regional stock market, which is why we have more stocks from that exchange than would be expected just from the country‘s GDP. Our ‘China‘ category includes Hong Kong as well as ‘mainland‘ stocks, but all the shares we include are listed, and tradeable, on the Hong Kong exchange; dealing on the Shanghai and Shen Zhen exchanges is not easy for private investors. We include a lot of Korean companies, because we think this stock market is currently one of the most interesting in the world. We show, perhaps, fewer US companies than you might expect; this is because that country‘s stocks have the most available online information in the world, whereas Robur brings you data that is, for most investors, harder to find.

It is because ‘one size does not fit all‘ in equity research, that the Robur Terminal allows you to select the criteria which you think most important for the companies, and sectors, that you are interested in. You can set your own priorities. This may sound a little daunting but in fact, like most investment analysis, it‘s mostly common sense. To learn a bit more about the Robur ranking system, click here. The tool itself allows you to switch off things you don‘t want in your outputs; for example, revenue growth would be switched off for most financial businesses (banks rarely report ‘revenues‘ at all).

We suggest that one focus should be the company cash flows. Cash flow statements are often rather difficult for individual investors, so Robur provides graphical means of showing you what is actually happening. Cash is important because profit numbers can be manipulated in all sorts of clever ways, but cash is less forgiving of accounting manipulation. We believe, for example, that a company that is increasing its revenues, but growing working capital requirements at a lower rate, is doing something quite clever; and if they are increasing revenues, and increasing operating cash flow, and generating increased free cash flow, year on year, that‘s a sign of good management; it‘s not at all an easy thing to do. Of course you need to think about other things: current ratios (current assets : current liabilities) will be found on the balance sheet, but they are helpful alongside the cash flow statements to assess solvency.

Our cash flow graphics will be helpful, we hope, because they highlight where the cash is coming from and where it is being spent. Thus you can see at a glance how much cash comes from operations, as well as borrowings and share issues, and how much goes on capex, repayment of debt, dividends and (our personal bugbear) buying back the company‘s own shares. We soon get used to a ‘good‘ pattern of the cash graphics for a particular sector (the ‘good‘ pattern for industrial businesses looks different from the ‘good‘ pattern for service and financial businesses, for example.)

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