How to Evaluate a Company

7/29/2019 How to Evaluate a Company

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How to Evaluate a Company's Balance

Sheet

June 03 2011| Filed Under Investing Basics

For stock investors, the balance sheet is an

important consideration for investing in a

company because it is a reflection of what the

company owns and owes. The strength of acompany's balance sheet can be evaluated by

three broad categories of investment-quality

measurements: working capital adequacy, asset

performance and capitalization structure.


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Tutorial: Financial Statement Analysis In this

article, we'll look at four evaluative perspectives

on a company's asset performance: (1) the cashconversion cycle, (2) the fixed asset turnover

ratio, (3) the return on assets ratio and (4) the

impact of intangible assets.

The Cash Conversion Cycle (CCC)

The cash conversion cycle is a key indicator of

the adequacy of a company's working capital

position. In addition, the CCC is equally

important as the measurement of a company's

ability to efficiently manage two of its most

important assets - accounts receivable and

inventory.


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Calculated in days, the CCC reflects the time

required to collect on sales and the time it takes

to turn over inventory. The shorter this cycle is,the better. Cash is king, and smart managers

know that fast-moving working capital is more

profitable than tying up unproductive working

capital in assets.

CCC = DIO + DSO

DPO

DIO - Days Inventory Outstanding

DSO - Days Sales Outstanding


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DPO - Days Payable Outstanding

There is no single optimal metric for the CCC,

which is also referred to as a company's

operating cycle. As a rule, a company's cashconversion cycle will be influenced heavily by

the type of product or service it provides and

industry characteristics.


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Investors looking for investment quality in this

area of a company's balance sheet need to track

the CCC over an extended period of time (forexample, five to 10 years), and compare its

performance to that of competitors. Consistency

and/or decreases in the operating cycle are

positive signals. Conversely, erratic collection

times and/or an increase in inventory on hand

are generally not positive investment-qualityindicators. (To read more on CCC, see

Understanding the Cash Conversion Cycle and

Using The Cash Conversion Cycle.)

The Fixed Asset Turnover Ratio


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Property, plant and equipment (PP&E), or fixed

assets, is another of the "big" numbers in a

company's balance sheet. In fact, it oftenrepresents the single largest component of a

company's total assets. Readers should note that

the term fixed assets is the financial

professional's shorthand for PP&E, although

investment literature sometimes refers to a

company's total non-current assets as its fixedassets.

A company's investment in fixed assets is

dependent, to a large degree, on its line of

business. Some businesses are more capital

intensive than others. Natural resource and large

capital equipment producers require a large

amount of fixed-asset investment. Service

companies and computer software producersneed a relatively small amount of fixed assets.

Mainstream manufacturers generally have

around 30-40% of their assets in PP&E.

Accordingly, fixed asset turnover ratios will vary

among different industries.


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The fixed asset turnover ratio is calculated as:

Average fixed assets can be calculated by

dividing the year-end PP&E of two fiscal periods

(ex. 2004 and 2005 PP&E divided by two).

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This fixed asset turnover ratio indicator, looked

at over time and compared to that of

competitors, gives the investor an idea of how

effectively a company's management is using this

large and important asset. It is a rough measure

of the productivity of a company's fixed assets

with respect to generating sales. The higher thenumber of times PP&E turns over, the better.

Obviously, investors should look for consistency

or increasing fixed asset turnover rates as

positive balance sheet investment qualities.

The Return on Assets Ratio

Return on assets (ROA) is considered to be aprofitability ratio - it shows how much a

company is earning on its total assets.

Nevertheless, it is worthwhile to view the ROA

ratio as an indicator of asset performance.


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The ROA ratio (percentage) is calculated as:

Average total assets can be calculated bydividing the year-end total assets of two fiscal

periods (ex 2004 and 2005 PP&E divided by 2).


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The ROA ratio is expressed as a percentage

return by comparing net income, the bottom line

of the statement of income, to average totalassets. A high percentage return implies well-

managed assets. Here again, the ROA ratio is best

employed as a comparative analysis of a

company's own historical performance and with

companies in a similar line of business.

The Impact of Intangible Assets

Numerous non-physical assets are considered

intangible assets, which can essentially be

categorized into three different types:

intellectual property (patents, copyrights,

trademarks, brand names, etc.), deferred

charges (capitalized expenses) and purchased

goodwill (the cost of an investment in excess ofbook value).


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Unfortunately, there is little uniformity in

balance sheet presentations for intangible assets

or the terminology used in the account captions.Often, intangibles are buried in other assets and

only disclosed in a note to the financials.

The dollars involved in intellectual property anddeferred charges are generally not material and,

in most cases, don't warrant much analytical

scrutiny. However, investors are encouraged to

take a careful look at the amount of purchased

goodwill in a company's balance sheet because

some investment professionals are

uncomfortable with a large amount of purchased

goodwill. Today's acquired "beauty" sometimes

turns into tomorrow's "beast". Only time will tell

if the acquisition price paid by the acquiring

company was really fair value. The return to theacquiring company will be realized only if, in the

future, it is able to turn the acquisition into

positive earnings.


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Conservative analysts will deduct the amount ofpurchased goodwill from shareholders equity to

arrive at a company's tangible net worth. In the

absence of any precise analytical measurement

to make a judgment on the impact of this

deduction, try using plain common sense. If the

deduction of purchased goodwill has a material

negative impact on a company's equity position,

it should be a matter of concern to investors. For

example, a moderately leveraged balance sheet

might look really ugly if its debt liabilities are

seriously in excess of its tangible equity position.


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Companies acquire other companies, so

purchased goodwill is a fact of life in financial

accounting. Investors, however, need to lookcarefully at a relatively large amount of

purchased goodwill in a balance sheet. The

impact of this account on the investment quality

of a balance sheet needs to be judged in terms of

its comparative size to shareholders' equity and

the company's success rate with acquisitions.This truly is a judgment call, but one that needs

to be considered thoughtfully.


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Watch: Balance Sheet

Conclusion

Assets represent items of value that a company

owns, has in its possession or is due. Of the

various types of items a company owns;

receivables, inventory, PP&E and intangibles are

generally the four largest accounts in the assetside of a balance sheet. As a consequence, a

strong balance sheet is built on the efficient

management of these major asset types and a

strong portfolio is built on knowing how to read

and analyze financials statements.


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To learn more about reading balance sheets, see

Breaking down the Balance Sheet, Reading The

Balance Sheet and What You Need To KnowAbout Financial Statements

Read more:

http://www.investopedia.com/articles/basics/06/assetperformance.asp#ixzz27vuDjM4T

How to Evaluate a Company

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