To The Moon

How to qualify a business?

Here's a framework for evaluating a company's financial performance:

Income Statement

1. Revenue (or Sales):

   Evaluation: Look for trends in revenue growth or decline over time. Consistent growth can indicate market demand and business expansion, while erratic or declining revenue might signal market or operational issues.

   Metric: Year-over-year growth rate.

2. Gross Margin (Gross Profit / Revenue):

   Evaluation: This shows how much money is left after covering the cost of goods sold (COGS). A stable or increasing gross margin suggests good cost control or pricing power.

   Metric: Percentage change in gross margin.

3. Net Income:

   Evaluation: The bottom line shows overall profitability. It's important to understand what drives changes in net income, whether it's operational efficiency, tax changes, or one-time events.

   Metric: Net Income Margin (Net Income / Revenue).

I do not use EBITDA. It has to be net income.

Balance Sheet

1. Total Assets:

   Evaluation: Growth in assets might indicate investment in growth, but it's crucial to analyze the composition (e.g., cash vs. goodwill).

   Metric: Total Assets Growth Rate.

2. Current Ratio (Current Assets / Current Liabilities):

   Evaluation: Measures liquidity or the ability to cover short-term obligations. A ratio above 1 is generally good, but very high ratios might indicate inefficient use of resources.

   Metric: Current Ratio Value.

3. Debt to Equity Ratio (Total Liabilities / Shareholders' Equity):

   Evaluation: Indicates the company's financial leverage. High ratios can mean higher risk due to debt obligations but might also support growth if managed well.

   Metric: Debt to Equity Ratio.

The other item I look into is retained earnings (perpetual profitability of the business).

Cash Flow Statement

1. Net Cash Provided by Operating Activities:

   Evaluation: This shows how much cash is generated from core business operations. Positive and growing cash flow here is a strong sign of operational health.

   Metric: Operating Cash Flow Margin (Operating Cash Flow / Revenue).

2. Capital Expenditures (CapEx):

   Evaluation: Indicates how much is being spent on maintaining or expanding the asset base. High CapEx can be a sign of growth investment, but it should be sustainable with operating cash flow.

   Metric: CapEx as a percentage of Operating Cash Flow.

3. Free Cash Flow (FCF):

   Evaluation: FCF represents cash available after maintaining or expanding assets. It's crucial for funding growth, dividends, or debt reduction without external financing.

   Metric: Free Cash Flow Yield (FCF / Market Capitalization).

If I had time for only one metric, I would look at the company’s free cash flow.

Framework for Evaluation:

• Trend Analysis: Look at how these metrics have changed over time (at least 5 years if possible) to understand growth, stability, or volatility.

• Comparative Analysis: To gauge relative performance, compare these metrics with industry benchmarks or competitors.

• Correlation and Impact Analysis:

  How does revenue growth correlate with changes in gross margin?

  Does an increase in assets correlate with improvements in operational cash flow, or does debt finance it?

  How does CapEx affect Free Cash Flow, and what does this say about investment for future growth vs. current operational needs?

• Sustainability and Quality of Earnings:

  Assess if the net income is backed by strong cash flows (high-quality earnings) or if there are significant non-cash adjustments.

  Evaluate if the balance sheet strength supports the income statement performance or if there's reliance on debt.

• Future Outlook: Use these metrics to infer the company's ability to sustain growth, manage debt, and invest in opportunities without compromising financial health.

This framework provides a balanced view of profitability, liquidity, efficiency, and growth potential, helping to paint a comprehensive picture of a company's financial health.

Summary

I look for increasing revenue and net profit, as well as items like growing net assets (assets minus liabilities) and retained earnings. I also look for a growing FCF.

This represents the quantitative assessment (financials). Let us consider other qualitative items like competitive advantages, branding, and goodwill within the industry. If possible, I prefer the founder to be actively involved in the business. My experiences would lead me to other items related to inventory and freight expenses.

This is a start to qualifying a business. For some companies, a trend of reducing net losses can be a worthy consideration too. This is the start and not the end of the qualification. Let us add our circle of competence as a qualifier too.

What works for me, may not work for another. It is good to learn as we finetune our investing strategies. I wish you investing success.

@TigerStars

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