When analysing companies, investors need to be aware of certain financial metrics. Such metrics provide important information on how a company is performing, and they may also warn of impending deterioration in the business in future periods. Such early warning signs are crucial in helping investors avoid debilitating losses.
Risks abound in investing, and one can never be too careful when it comes to identifying warning signs of impending stress. While businesses definitely do face challenges time and again, remember that it is the great ones that manage to overcome adversity and emerge stronger, while the weak or imprudent ones end up falling by the wayside.
Here are four important metrics (along with examples) that can help investors avoid big losses.
1. Profit margins
Gross and net profit margins are a key feature of how well companies convert revenue into profit. Gross margin is a measure of pricing power, while net margin measures the efficiency of operations and an organisation’s cost structure. If a previously high-margin business sees continued margin erosion, this is a big red flag that should make investors start questioning management.
For example, companies such as Straco Corporation Limited (SGX: S85) and Singapore Exchange Limited (SGX: S68) have very high net profit margins of 34.6% and 43.6%, respectively (measured using their latest quarter), and this provides them with a good buffer in case any stress pops up within the business.
2. Free cash flow
Free cash flow (FCF) is computed as operating cash flow minus capital expenditures and represents the cash available to the company for paying dividends, buying back shares, or simply letting it accumulate on the balance sheet. Companies that generate consistent and regular streams of FCF are less likely to get into financial trouble, as it implies their core business is generating healthy levels of operating cash flow, and that the company isn’t reliant on debt or loans to sustain itself.
For example, Genting Singapore Ltd (SGX: G13) has generated five consecutive years of positive FCF.
3. Dividend yield
For companies that pay a dividend, investors can compute the dividend yield of that company by taking its dividend per share and dividing it by the share price. Interestingly, dividend yield is historical, meaning it tells us what the company used to pay out in dividends, and can, therefore, be somewhat misleading.
Very high dividend yields (e.g., around 8% to 10%) may signal a deterioration in the underlying business, resulting in further dividend cuts going forward. This can be a signal for investors to dig further, rather than just accepting the “high” yield at face value.
A good example is Hutchison Port Holdings Trust (SGX: NS8U), which has a trailing dividend yield of around 10.2%. The trust has seen dividends reduced in the last few years, so the trailing dividend yield can be very misleading.
4. Debt levels
High debt levels can cripple an otherwise good business, as finance costs can pile up over time into a significant expense, sucking away all the operating profit. Investors need to assess a business’ debt levels with respect to its cash position, cash-generation capability, and also equity base, to name a few. Debt levels are termed “excessive” when the company has hardly any profit left after deducting finance expenses.
For example, in the recent Q1 2020 earnings report from Neo Group Limited (SGX: 5UJ), a leading caterer and integrated food solutions provider, it reported a loss before income tax of S$676,000, while finance costs for the quarter amounted to S$1.1 million, a 65% year-on-year jump. Gross debt on its latest balance sheet stood at S$75.2 million, while its cash balance was just S$14.9 million.
The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. The Motley Fool Singapore has recommended shares of Singapore Exchange Limited and Straco Corporation Limited. Motley Fool Singapore contributor Royston Yang owns shares of Singapore Exchange Limited and Straco Corporation Limited.