When I started investing 10 years ago, I can remember vividly how confused I was when it came to analysing a company’s financial statements. There are so many ratios out there and I was not sure which ones I should use. In the end, I just used all of them for my screening and analysis, and it was confusing looking at everything.
After many years of investing, I realized that you don’t have to use all the ratios and some of the ratios have overlapping uses. I am a firm believer of the Pareto principle which means that 80% of the results comes from 20% of the causes.
So, I decided to ‘Marie Kondo’ my financial screening template and zoom in on the ratios that are important to yield better results. I put a heavy weight on these four ratios. By using them, you can sniff out good companies and filter out the bad ones.
1. Gross profit margin
Gross profit margin shows the amount of gross profits as a percentage of revenue. Companies that have a low gross profit margin usually have trouble achieving healthy net profits because they do not have room for error. Hence, companies with low gross profit margins tend to have low net profit margins too.
Having a high gross margin gives companies better opportunities to make wise decisions on capital allocation than companies with low gross profit margins. As a rule of thumb, I like companies that have at least a 20% gross margin.
2. Return on equity
Return on Equity (ROE) measures how effective the company is at generating profits for every dollar it has in equity. When comparing ROE within an industry, a company that is able to consistently generate a higher ROE tends to have the competitive advantage. A declining ROE usually means poor capital allocation decisions followed by the possibility of losing its market position. I like to look for companies with ROE of at least 10% or more.
3. Quality of income
In the business world, it’s normal for a company to provide credit terms, which means that the company does not get paid immediately after providing a product or service. The credit term may be any amount of days.
For instance, if a company gives a credit term of 30 days, they will provide their service, then collect the money from their customers up to 30 days later. There will be cases where the company is unable or takes a long time to collect the credit. This results in low cash flow although the profit is already reflected in the income statement. Hence, I always like to use the quality-of-income ratio.
The quality-of-income ratio measures every dollar of operating cash flow generated for every dollar of net income. Good companies usually have a ratio above 1.0 which means that the quality of income is high.
For instance, if the company has a consistent ROE of 15% and yet its quality-of-income ratio is consistently below 1.0, then its ROE is of lower quality because the income may be just a gain on paper and the company has trouble collecting back their payments. Cash flow is always king when it comes to running a business — no point recording high profits with low cash flows.
4. Debt to equity
The last thing you want to do is invest in a company that has a serious debt issue which might cause heavy investment losses when the company goes bankrupt or gets diluted through equity fund raising. Hence, screening by the debt-to-equity ratio helps you filter companies that may have too much debt.
The ratio measures the amount of debt the company has compared to its equity. Having some debt is not necessary a bad thing — it is how the company manages its amount of debt that matters. As a general guideline, companies with debt-to-equity ratio of less than 0.5 usually have manageable debt levels.
The fifth perspective
Of course, these four ratios don’t paint the entire picture; you still need to evaluate a company’s business model, growth drivers, and risk factors among other things. So, you should never invest in a stock just based on these four ratios alone.
However, I’ve found that these four ratios have worked especially well for me when it comes to screening for investment ideas and finding great companies to start my research on. So go ahead and use them, and see what investment ideas you can find for yourself.