When purchasing a stock or equity position in a company you want to make a wise choice. In order to make the wise choice you must filter out what I call equity marketing noise. This means looking at a few numbers. One should look at how much cash and receivables a company has as compared to both its short and long term liabilities. Forget about all the working capital ratios, earnings per share and price earnings ratios because they often do not tell the truth.
Cash and receivables when compared to short and long term liabilities represents a company’s ability to pay now. Using inventory in the ratio does not account for recession risk, or what I call demand risk, so strip it out. How would a company pay its short term liabilities if demand suddenly decreased (can’t move inventory)? Removing other receivables from the equation is also wise because often times this number contain amounts owed by related entities that may have no ability to pay. Items such as good will should also never be included because it is intangible, or of no real value in time of a recession, let alone anytime.
One can use all the fancy math and equations you like and find that your analysis paralyzes you from making a good decision, or alters your perception. By considering the cash flow that is outlined above you reduce your risk of making a bad decision. Couple this with gross margin which is sales dollar minus direct input costs such as material and labor. Next reduce this margin by the selling, general and administrative costs. Then compare that percentage of the sales dollar to the competition. This will tell you if the executives are overpaid, if marketing and selling expenses are truly returning on investment, and if there is waste in overhead. Choosing a company with the strongest cash position, and the strongest margin after subtracting the above expenses will tell you all you need to know to make a wise decision.
Remember keep it simple.