Last week, we took a look at some of the most important metrics for getting a quick understanding of a firm’s financial health, valuation, and asset base. In that post, we mentioned that more metrics are typically better, helping us to filter out erroneous signals from individual numbers. Today, we’re going to begin conducting a deeper-dive into some of the basic concepts that can help us reach a whole new level of strategic insight when evaluating equities.
We’re moving beyond “back-of-the-envelope” style measure now: those are great for quickly identifying a potentially undervalued stock. But a few ratios will never be enough to understand the fundamental operations, structure, and plans of a firm. That’s why we’ve looked at reading annual reports as an essential window onto management’s thinking. Whether you’re parsing a 10-K or weighing a balance sheet, the terms we’ll discuss today are vital for getting all the profitable information you can out of such documents.
We’ve already covered some of the core terms associated with earnings analysis. Remember, earnings are vital, but tell us nothing about a firm’s accumulated debts and assets.
Balance Sheet Basics
- Assets: an asset is, essentially, property with value. Of course, this can be a broad and nebulous category, including a variety of intangible assets. The key test is that the property in question can be utilized to pay financial liabilities. This category can include everything from equipment to vehicles to land to public reputation.
- Current Assets: assets have to be
usableto pay liabilities—but some assets tie up value over a very long amount of time (a factory, for instance, may have immense value as an asset but have relatively little same-year resale value). "Current assets" refers to only those assets that can reasonably be turned into cash within one year. This category can include everything from inventory to stocks to accounts receivable. By looking at current assets, we move away from looking at a firm's long-term value and toward evaluating its shorter-term liquidity situation.
- Liabilities/Current Liabilities: liabilities represent, in short, future promises to pay with assets. As with current assets, current liabilities are those coming due in the next year. This category includes both traditional financial instruments like issued bonds and routine operational liabilities like accounts payable.
- Debt: unfortunately, the financial industry uses the term “debt” almost totally interchangeably with the more precise “liabilities.” Some analysts use it to refer strictly to traditional credit lines and bond issues, but commonly used metrics like Debt-Equity ratio, in fact, refer to all associated liabilities. “Debt” is always a term best read carefully in context when evaluating a stock.
- Equity: it’s easiest to think of equity as the “total accrued value” of a firm, the theoretical value of the firm to its owners after subtracting all liabilities from total assets. There’s basically no situation in which more equity isn’t
better,unless you’re concerned a firm is under-leveraged.
Cash Flow Clarity
We took a look at a “free cash flow,” last week, and a few readers have expressed a bit of confusion regarding the particular meaning of this concept. A few contextual terms are helpful for understanding. First, we have to understand that cash expenditures are sorted into two broad baskets:
- Capital Expenditures (most often referred to as CAPEX): this represents cash spent on assets. This includes both “maintenance” expenditures (ie. Replacing a machine that breaks) and “growth” expenditures (buying a second machine to cater to increased demand). Notably, maintenance expenditures should theoretically be equal to depreciation, which is essentially supposed to represent the growing probability of equipment replacement and/or maintenance over time.
- Operating Cash Flow: Here, we’re looking at money going in and out of the firm as part of normal operations (sale revenues, input and labor costs, etc.). This metric abstracts away from non-cash expenses like depreciation. A firm with negative operating cash flow is losing money on operations, even if it had no debt payments or asset depreciation.
- Free Cash Flow, then, is defined as operating cash flow minus capital expenditures. While much shorter on long-term detail, many investors see this metric as more reliable than the income statement: there are far fewer ways to fudge the accounting of cold, hard cash.
Once again, however, we want to avoid seeing Free Cash Flow as some sort of all-powerful metric. In fact, it’s a concept that can be misleading about a very particular kind of firm: a company pouring all of its free cash into growth capital. A firm like this isn’t “cash-strapped” at all, simply focused on growth. Determining the breakdown of maintenance v. growth CAPEX is thus essential for getting a savvy reading from free cash flow.
These metrics are just scratching the surface; we’ll explore some more advanced ideas in the coming days. In the meantime, if you’re interested in learning about how we’re using real-time stock analytics to power-up profits for smaller investors, we really recommend one of our virtual training seminars. They’re totally