Financial metrics are the key numbers that you can focus on in financial statements. There are three financial statements, the balance sheet, the income statement and the cash flow that we like to look at to find important metrics.
The 4 Most Important Financial Metrics for Rule #1
We’re going to look at some of the most important financial metrics that you as investors can use to evaluate a company. All examples and screenshots from this post are taken from looking at 10-year data on Whole Foods (WFM), from Guru Focus.
1) Liquidity on the Balance Sheet
The first important number we look at on the balance sheet is liquidity in the form of cash. Can the company you’re looking at really cover everything that they need to cover in the next year? Or have they somehow overloaded themselves with short-term debt and obligations that they could really run out of cash in the next year?
In order to evaluate this, we want to look at the current ratio. Essentially it is a measure of working capital. It compares the current assets, which are assets that can be turned into cash in the next year, with current liabilities, which are obligations that have to be paid in the next year.
What you want to look for when evaluating a company is a 2:1 ratio of liquidity to debt. Some companies are very well run that have lower ratios than that, because they are controlling their cash very well, or they are in an industry that isn’t growing fast so they don’t need as much liquidity.
These companies work their capital down so they don’t need as much cash on hand all the time and they can give that money to their shareholders. You will know that these companies are very well run because, they are really big companies.
Most companies, particularly smaller companies need at least a 2:1 ratio between current assets and current liabilities. That’s a great measure of liquidity. We call that the liquidity metric.
2) Earnings Growth and Growth of Net Income on the Income Statement
The income statement has a couple of important sets of key financial metrics.
The main ones are the growth of earnings and the growth of net income. What we are really looking for is if the company is growing. We look across the top and bottom lines of the income statement. Go back 10 years and see if the company is growing over 10 years. Are the numbers growing across the top line? What we want to see is that these lines of growth are parallel.
That means the sales growth rate is going up and so is the net earnings growth rate, and that these numbers are going up at the same growth rate.
If they are not, then the company might have earnings going up and the revenue is coming down.
Inch Wide Mile Deep: IBM and Growth
One company we are looking at right now, that we actually like is IBM. IBM’s revenue is coming down and their earnings are going up. You need to understand what you are looking at in your business, which is why you need to be a mile deep.
In IBM’s case they are moving out of hardware, which is a big revenue item, but not so much of a net earnings item. They’re moving into services and support, which is a lower revenue item, but at a lot higher earnings.
When you look at companies and see that something is a little off, it should trigger a question mark or a red flag and you have to go a mile deep and see if that is still OK in that particular company.
3) Return on Assets
We also look at return on assets which is using basically two of the financial statements. Return on assets, return on equity, and return on capital, are all measures of what the earnings are accomplishing, relative to the amount of money being used to get those earnings.
Really good companies can have really good returns. Having a 30% return per year isn’t that uncommon for really, really good companies.
Return on assets is an indicator of how profitable a company is relative to its total assets. Return on assets gives an idea of how efficient management is at using its assets to generate earnings.
4) Operating Cash Flow From the Cash Flow Statement
The next metric to look at is the cash flow statement. Is this company bringing in real cash? Is the company generating cash by selling off stock, borrowing money, or selling pieces of business? How is it getting the money?
What we want to see on the cash flow statement is the operating cash flow. I’m going to tell you something that’s really cool that we don’t see it as a metric that is on most cash flow statements. In fact, I don’t think I’ve ever really seen it. Some companies publish it but, it’s something that we Rule #1 Investors look for all of the time.
We take the operating cash flow and subtract the money put in for purchasing equipment. When we take that money out, which is called capital expense, we get owner’s cash flow or free cash. This is the money the company actually has available to give to the owner of the company to reinvest. That’s the money that we can put into our pocket, or the company can take and use to build the companies growth faster and faster.
We look to see if the company is bringing in real cash on the operating cash flow line. Not the investing line or the financing line, but the real cash flow line.
We use those key financial metrics from the income statement, the cash flow and from the balance sheet to determine how solid a company really is and if this company is something we want to invest in in the future.
It may sound a little complicated, but you will discover that as you get a mile deep into these things, that these numbers start to become comfortable. The more you practice with it the easier it will become for you.
Now that you know what statements to use to find these financial metrics learn these 5 numbers to determine if you’re making a smart investment. The Big 5 Numbers are a huge clue as to whether or not you’re looking into a business that is predictable and can be trusted to deliver at least 15% year after year. Click the button below to learn more.
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