The Little Book of Value Investing by Christopher H. Browne

Balance Sheet - how much money the company owes and its net worth

• Current assets : cash and assets that can be turned into cash in a relatively short period
  • T-bills
  • Inventories that are finished products ready for sale or products that are in process of being manufactured
  • Receivables from customers who have bought their products
• Current liabilities : debts that fall due within a year or less
  • Interest payment on company borrowings
  • Account payable to the company's suppliers
  • Taxes owed but not yet paid
• Current Ratio = Current Liabilities / Current Assets
  • Companies ability to pay its short-term obligations
  • Guideline: 2-to-1 ratio
  • Compared with other companies, LOWER ratio means possible LIQUIDITY PROBLEM
  • Steadily declining year over year means SERIOUS LIQUIDITY PROBLEM
• Working Capital = Current Assets - Current Liabilities
  • Guideline : The more the better
• Quick Ratio = (Current Liabilities / Current Assets) - Inventories
  • Rising inventories may indicate a product that has decreased in popularity and will be difficult to sell at a profit
• Long-term assets
  • Real estate, Factories, Warehouses and equipment
  • Investment in subsidiaries or stocks that is not intended to be sold
  • Intangible assets such as patents, trademarks, copyrights (usually not taken into consideration because difficult to get exact valuation)
• Long-term liabilities
  • Bank loans
  • Public and private bond issues
  • Long-term leases for property or equipment
• Shareholder Equity (Book value) = Assets - Liabilities
  • Liabilities growing faster than assets means company has to borrow more and more money just to stay afloat
• Debt-to-Equity Ratio = Total Debts / Shareholder Equity
  • Guideline: less than 1
  • If number is higher than 1, company is funded primarily by debt rather than equity investment

Income Statement - how much money the company took in over a period of time (sales or revenue) and how much it paid out (expenses)

• Company's sales or revenues
  • To be compared to previous years
  • Guideline: Revenues growing over time
• Cost of goods sold : direct cost of producing product or service the company sells
  • Raw materials
  • Manufacturing or labor costs of making product
  • INCREASING % of (COGS / revenues) means rising costs that cannot be passed on to the costumers are squeezing the long-term potential for profit
• Gross profit = Revenues - COGS
• % Gross Profit Margin = Gross Profit / Revenues
  • Guideline: steadier gross profit margin means better business
• Operating expenses : selling, general and administrative expenses
  • Guideline: Lower % of (Operating Expense / Revenue) is better
• Operating Profit (EBIT : Earnings Before Interest and Taxes) = Gross Profit - Operating Expenses
  
• Net Profit (Final Earnings) = Operating Profit - Interest Expense - Taxes - Depreciation
  
• Earnings Per Share (EPS) = Net Profit / Outstanding Shares
  • Diluted EPS : taking into consideration stock options, issued bonds, preferred stock or warrants are converted to stock
  • Guideline : Diluted EPS very much lower than EPS means earning is not as cheap
  • Recommended to use EBIT instead of Net Profit
    
• Questions on Trend over 5 or 10 years:
  • Are revenues rising or falling?
  • Are expenses staying in line with revenues?
  • Are profits consistent or uneven?
  • Is there a cyclical pattern to earnings such as would be the case with economically sensitive companies?
  • Are profits growing?
  • Are there a lot of one-time charges or gains to indicate the company may be manipulating or massaging the bottom line?
  • Are shares outstanding decreasing?
    • Rising shares outstanding indicate excessive stock options are being granted to executives and will dilute share of corporate profits
    • Company is financing itself through stock offerings rather than earnings
• Return on Capital (ROC) = Earnings / Beginning Year Capital (stockholder Equity + Debt)
  • Rising ROC means company is doing a good job of reinvesting profits
• Net Profit Margin = Earnings / Total Revenues
  • Guideline: avoid companies with declining Net Profit Margin

The book The Little Book of Value Investing (Little Books. Big Profits) can be obtained from Amazon.