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How to Find Winning Companies – Part 4

Welcome to the fourth part of the series on using an annual report to find a winning investment!

As a recap: In order to find the best share to invest in, the first thing an investor has to do is gain an understanding of the company. And, one way to gain that understanding is by reading the company’s annual report.

You can catch up on the previous three articles in the series here: Part OneTwo, and Three.

In the third article, I shared a few tips on how we can gain important context about a company’s business. In this article, let’s get into understanding the company’s financials.

We’ll continue to use land transport giant ComfortDelGro Corporation Limited (SGX: C52) as an example. You can find the company’s latest (2013) annual report here.

Start with the basics

When it comes to financials, I like to answer the basic questions first. The financial statements are from page 78 onwards. Here are a few of those basic questions that come to mind:

  1. Does the company have cash and no debt?
  2. How can it fund its future growth? Is it cashflow positive?
  3. Has the company been able to grow its top-line and maintain its profit margins at the same time?

As you can see from the graph below, the cash on hand at ComfortDelGro’s balance sheet has been growing since 2009. Unfortunately, borrowings have also increased as well.

comfortdelgro balance sheet

Source: ComfortDelGro’s company earnings

The good news is that ComfortDelGro has been mostly free cash flow positive (free cash flow is defined as operating cash flow minus capital expenditure) since 2009. This is seen from the chart below. The operating cash flow, though, has been a little inconsistent – this may be worth investigating for further insight.

comfortdelgro fcf

Source: ComfortDelGro’s company earnings

As for my third point regarding the basic questions, ComfortDelgro has managed to steadily grow its revenue between 2009 and 2013 while keeping its net income margin fairly stable.

Have a checklist for financials

One good way to go through a company’s financials is to have a checklist. I have shared one such checklist by investor and author Pat Dorsey here. Dorsey’s nine-point checklist is summarised below along with my responses to each point with regard to ComfortDelGro’s financials:

  1. Minimum quality hurdle – Yes
  2. Presence of operating profit – Yes
  3. Consistent cash flow from operations – Yes
  4. Good returns on equity – Nope (more than 10% for only two out of last five years)
  5. Consistent growth in earnings – Yes, earnings per share has grown from 10.51 cents per share (2009) to 12.38 cents per share (2013).
  6. Clean balance sheet – Yes, debt to equity ratio is less than 40%.
  7. Free cash flow generation – Yes
  8. Occurrences of “other” charges – No frequent “one time charges”.
  9. Share count dilution – No major dilution. Share count has increased by 1.8% over the past five years.

There are many ways to go about investigating the financials of a company. It may also make sense to check for different elements for different businesses.

For the case of ComfortDelGro, investors may want to monitor the growth of goodwill within its balance sheet. Goodwill occurs when acquisitions are made by ComfortDelgro, therefore it might be one to keep an eye on since the company has been fairly active with acquisitions.

Footnotes

Another tip for understanding the financials is to look at the footnotes. In the footnotes, you would usually get hints on matters like how the company recognises revenue, or the content of each line item within the financial statements.

For example, page 92 of the report shows ComfortDelGro’s depreciation schedule for different assets from buses to buildings and furniture fittings. From there, the Foolish investor should judge whether or not the financial assumptions are conservative in nature or too aggressive.

That wraps up Part 4. Check back tomorrow for the final part!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.