If you were to buy a new car you would have a dashboard of check points you would want reassurance on before deciding to splash your cash.
How many miles are on the clock, what is its fuel consumption like, are the wheels about to fall off? There are measurements – metrics – we can take to establish all of those and plenty of others too.
Investing should be no different – you want to ensure your money is going to fuel acceleration for a long and fruitful journey together. And not into a vehicle which may look great on the outside but is badly maintained and worthy of the junkyard inside.
Which is why savvy investors have their own series of financial metrics by which they can do their due diligence on companies which pique their interest.
If there is one factor above all else that can make or break an investment, it is cash flow. Even if a technology is ground-breaking, the business model sound, and the team involved suited perfectly for the task at hand, a firm finding itself not generating sufficient funds to meet its immediate outgoings can stop it dead in its tracks.
Something which no investor wants to hear.
Therefore, being able to calculate the financial liquidity of a particular company should be a skill every diligent investor possesses.
A key metric is Current Ratio used to measure a company’s liquidity; it is calculated by dividing the value of its current assets by that of its current liabilities; the term ‘current’ refers to the short-term assets or liabilities the company possesses, typically those obtained/paid in the past year. A current ratio of 1.0 or higher suggests the company will be able to meet its commitments.
Operating Cash Flow
Another key financial metric is operating cash flow.
This is effectively the amount of money the company generates in its regular business – in short the money it makes set against its outgoings. It strips out additional methods of raising capital which can influence its bottom line such as the sale of stock or borrowed funds, but not provide a clear indication of its trading success (or otherwise).
To determine the amount brought in through the business’s normal working activities, we have to determine the operating cash flow (OCF) of the organisation. This is calculated by taking the operating income + depreciation from the company’s balance sheet and subtracting change in working capital + taxes.
The result should provide the investor with a clear indicator of the firm’s success – or otherwise – in its core business operation.
Earnings Per Share
Earnings per share is a financial metric used frequently by investors to calculate the profitability of a particular company on a per-share basis. This makes it an invaluable weapon in an investor’s arsenal for analysing the potential for increasing or decreasing gains from an investment by committing more heavily to a particular stock.
We calculate earnings per share by taking the company’s net profit and dividing it by the number of outstanding common shares. This word ’outstanding’ is important to note when discussing earnings per share. Some companies manipulate their earnings per share ratio by changing the number of outstanding shares, thereby inflating the perceived gains per share.
Sales Growth Rate
Although a far less complex financial metric to understand and calculate than those discussed above, the sales growth rate of an organisation is just as important.
Sales growth rate allows an investor to analyse the performance of the company’s revenue over a long timeframe, typically looking back five to ten years in its finances, to see how much the company’s total sales have grown per annum.
It is calculated by subtracting the revenue from the previous period (in this case per year) from revenue of the current period, then dividing the result by revenue from the previous period and multiplying this number by 100 to represent the data as a percentage.
By getting into the habit of using these metrics, it can provide investors with a clearer indication of a company’s performance and help determine whether the stock is worthy of your investment.
Investors should recognize and accept the risks associated with investing.
Certain investments may require you to keep your holding for periods of many years with limited or no ability to resell unless there is a strongly regulated secondary market.
You may also have limited access to periodic reporting, see your holdings decrease and increase in value, or even lose your entire investment.
Investors should decide for themselves whether to make any investment, basing this on their own independent evaluation after consulting with financial, tax and investment advisors.