Investing Intelligently: Part 4 (How much cash and debt is it carrying? What's the inventory telling you?)

In Part 3 we looked at the company's gross and operating profit margins, to make sure we find investment opportunities that are not only increasing sales at a rate of 10+% but also are increasing net earnings at a double-digit rate. Before we turn our attention to the Balance Statement, I want to make a couple more points off of the Income Statement.

Previously, I mentioned that Research & Development expenses are a part of the formula for determining a company's operating margin for the period. R&D is something that you will want to pay attention too when you are searching for companies to invest in. Specifically, you will want to see how the company's R&D expenses compare with its competitors. If a company is not spending nearly as much as its competitors on R&D that could be a sign that in the coming months, quarters, and years ahead, it will also lag behind in the technology gap. R&D is all about improving existing products and developing new ones, so if a company isn't investing in its future, you shouldn't either. A little tidbit -- if you see a company pouring a ton of capital into its R&D (especially in comparison to its competitors), this can be a positive sign that it plans to unveil a host of new products in the very near future.

A second point I want to briefly make concerning the Income Statement, has to do with the number of shares outstanding the company currently lists. Usually, at or near the last line on an Income Statement, you will see a line that lists the total number of "Diluted" shares outstanding for the period. Compare this number against the prior 3 to 5 years and get a sense of the trend. Is it issuing a lot of new shares every year? Or is its share dilution fairly moderate like low single digits? This is important to follow, because as a shareholder, you own a certain number of shares in the company - that is your percentage of ownership. That percentage of ownership declines whenever the company issues new shares. So you will want to keep track of how many new shares it is issuing each period. If it is in the low single digits, you can live with that. If it is consistently in the high single digits or even double-digits, I wouldn't rule the company out entirely, but it certainly raises a red flag.

Another point regarding shares, sometimes you will see a company buying back its shares. As a shareholder, this means your share of the overall pie increases with each share that is bought back by the company. If a company is buying back some of its shares (often called a stock buyback plan) this can be a sign of a number of things: (1) the executives feel that the stock is undervalued and it is a good use of the company's cash to buyback some of its shares, (2) the company wants to juice its earnings-per-share (we will discuss ratios and different measurement formulas later), by reducing the number of shares outstanding, (3) the company doesn't see a better use of its cash like issuing dividends, or investing in new facilities, or spending R&D, or buying a competitor, or (4) all of the above. Some investors love it when companies buy back shares. I have no opinion on it either way. I don't necessarily think it is THE best use of cash, but I also don't think it is THE worst use of cash either.

Enough on that. Turning to the Balance Sheet, there is a couple things that I am always on the lookout for. First, does the company have a nice cash cushion? On a Balance Statement, you will see a line that reads "Cash and Cash Equivalents" and "Short-term Marketable Securities." These two lines tell you how much cash the company has on hand (in the former), and how much cash it has immediate access too (in the latter). Here, it is useful comparing the company's cash and short-term securities positions with its competitors. Second, does the company have control over its long-term debt? The usual definition of long-term debt is a debt obligation that is not set to mature for at least a year or more (as opposed to short-term debts that mature within a year). Again, comparing the company's long-term debt to its competitor is a useful exercise. Investors are all over the map on this one too and whether the company should be carrying any debt at all. Some investors prefer companies with little or no debt on its books. Others prefer companies with some debt on its books because it is a sign that the company sees substantial growth ahead and it is doing all that it can to realize that growth as fast as possible. I lean more to this latter view. In a society inundated in debt, the term rightfully carries a negative connotation. In reality, debt, when used smartly, can be a very useful thing as it can give a company access to more capital to do more business with -- in this sense, it gives a company "leverage." I like to see companies using some leverage because it shows that the company is confident in its future growth prospects.

Third, what is the company's inventories telling you? Compare the company's current inventories against its inventories in the prior period. Is it increasing? Is it decreasing? If inventories are increasing (especially substantially) it can be a sign of one of two things: (1) it may indicate that consumers are not buying as much of the company's goods as the company expected; this is a bad thing because it usually means that in order to reduce the inventory to normal levels it has to sell the goods at fire-sale prices which then impacts the company's gross and operating profit margins. Or (2), it may indicate that the company is just about to hit the stores with a new product line; this is a good thing because it means higher sales growth is just around the corner. So how do you know if it is the first scenario or the second scenario? The only way you can know is by listening in on the company's latest quarterly earnings conference call. Every investor (that includes you) can listen to the company's CEO and CFO talk about the state of a company through the quarterly conference call. If you go to the company's website and click on its Investor Relations page, frequently it will have a link directing you to either a webcast of the company's latest or upcoming call, or a phone number that you can call and listen through your cell phone. Other websites like Yahoo Finance also provide links to conference calls. In my opinion, conference calls are one of THE BEST WAYS TO LEARN ABOUT A COMPANY. I cannot over-emphasize that point enough. Frequently, you will gain information in a conference call that you just cannot gain from the cut-and-dry data of financial statements. This is the only way, for instance, that you are going to know whether the sharp increase in inventories is a sign that it has an overstock of unwanted product, or whether it has a new stock of product about to hit stores.

Next, we will turn our attention to the Cash Flow Statement. We will also go over a couple measurement tools that you will want at your disposal like EV/FCF (Enterprise Value to Free-Cash-Flow) and ROIC (Return on Invested Capital).

Peace

Jeremy