In this edition, we are going to look at a simple 7-point financial analysis framework that can help you identify good companies:

1. Revenue growth

2. Free cash flow

3. Free cash flow growth

4. Free cash flow margin

5. Return on capital employed

6. Return on invested capital

7. Debt

1. Revenue growth

In the long-run revenue growth is the biggest driver of total shareholder return. The graph below shows that over 10 years, 74% of total shareholder return was driven by revenue.

But we don’t need a graph to prove that to us. We understand that revenue is the top line and if revenue isn’t growing, then profit can’t grow, which means that free cash flow can’t grow, which means that the business value can’t grow.

You can calculate annual revenue growth using this formula:

Mature businesses grow at around 2%-5% per annum, so if you can find a business doing more than that, it could be a good sign. As a rule-of-thumb, above 10% is very good.

2. Free cash flow (FCFF)

You can calculate FCFF as follows:

FCFF = cash flow from operations - capital expenditures

This is quite easy to calculate and only requires two numbers. Both of those can be found in the cash flow statement.

Capital expenditures (or capex for short) is the amount a company spends to buy or maintain fixed assets (i.e. buildings, equipment, computers, vehicles, machines, etc).

It is clearly preferable to have positive free cash flow. But the number can be negative if the company is investing heavily. If it is negative dig deeper and find out if it is due to investment or poor profits.

If want to go deeper, I have previously explained free cash flow in detail here.

3. Free cash flow growth

Free cash flow is the main driver of business value, so you want to see it growing from year to year. The calculation is the same as for revenue growth.

The higher the growth, the better. But again, anything above 10% is very good.

4. Free cash flow margin

Free cash flow margin = FCFF / Revenue

This formula shows you what percentage of revenue ends up as free cash flow. The more the merrier, but 10% is good. In some extraordinary business like Novo Nordisk, this number is around 35%. That is an exceptionally high number, don’t exclusively benchmark against that.

5. Return on Capital Employed (ROCE)

ROCE = EBIT / Capital Employed

EBIT is Earnings Before Interest and Taxes. It is also known as operating profit.

Capital employed is a more involved calculation, so I’m going to show you a shortcut. You can approximate capital employed as:

Capital Employed =  Total Assets – Current Liabilities

ROCE shows us the return that the company earns on the capital used in the business. It includes both debt and equity capital, so it is a comprehensive return measure.

6. Return on Invested Capital (ROIC)

You also get a formula called Return on Invested Capital (ROIC). The formula is:

ROIC = [EBIT x (1-Tax rate)] / Invested Capital

Look familiar? It is pretty close to ROCE. There is an extra tax term in the numerator and the denominator is called Invested Capital.

Some people say that capital employed and invested capital are different things, but they are virtually the same.

For ease of use lets make Capital Employed = Invested Capital. That means the only difference between ROCE and ROIC is the effect of tax. ROCE is before tax and ROIC is after tax.

ROCE will give you better comparability amongst companies in different countries where different tax rates apply. But eventually taxes have to be paid, so ROIC will give you a better approximation of the return that particular company can achieve for you.

My recommendation - don’t over think this. ROCE is easier to calculate, start with that one. Anything above 15% for either ROCE or ROIC is excellent.

7. Debt

Too much debt is a bad thing, but almost all companies use debt to some extent. Some of the best companies in the world use large amounts of debt because they have steady businesses and can afford to pay off the debt. Let’s examine debt using 3 ratios.

7.1 Equity to assets

Equity to Assets ratio = Equity / Total assets

This ratio shows you what percentage of assets are funded by equity. As a rule of thumb, the higher the percentage, the less likely it is that the company can go bankrupt.

But you have to look at this ratio in relation to where the business is at the time. For instance a mature company like Apple has a ratio of 18%. That means 82% of the business is financed by debt. If the business slows down, that might be a concern, but Apple is juggernaut, so it might be okay for them.

7.2 Interest to EBIT

Interest to EBIT ratio = Interest / EBIT

This ratio shows you the percentage of operating profit that is required to pay interest on the debt. The lower, the better. For Apple, this ratio is 3.4%. Interest is a small cost to them.

7.3 Debt to free cash flow

Debt to free cash flow = Total Debt / Free Cash Flow

This ratio shows you how many years of free cash flow would be consumed in paying off all the debt. In Apple’s case this comes to 1.4 years, so it would take them 17 months to pay all their debt. Not bad at all.

When viewed together, these three debt ratios show that Apple has a high amount of debt, but both the interest payments and the debt repayments are manageable compared to Apple’s ability to pay.

Conclusion

This analysis has answered these questions:

• Growth – are revenue and free cash flow growing?

• Margins – how much of revenue is converted to free cash flow?

• Returns – what return is the company achieving compared to other companies?

• Debt – can this company manage its debt burden?

There are a lot of other questions that need to be answered, but these basics are powerful. They can prevent you from investing in a bad company and they can help you find good companies.

Happy investing!

I would like to hear what you’re up to.

DM me on social media or email me.