A Financial Checkup
...on Drips

by George Runkle (TMFRunkle)

ATLANTA, GA (April 5, 1999) -- To me, one of the more important things to do with my direct investments is to periodically check up on them. While I do try to take advantage of dips in the prices, I think the financials of the individual companies are more important. Since I'm basically a lazy person, I developed a spreadsheet to figure most of the financials for me. I have a number of different benchmarks that I threw in, and then I put in the company financial data to see how it is doing.

Last year, Compaq (NYSE: CPQ) showed up as a possible buy based on many of my figures and its low debt. However, it had rotten inventory turnover compared to Dell (Nasdaq: DELL); also, compared to Dell, it wasn't as profitable looking at return on assets and other measures. However, unlike Dell, it carried no debt. I decided to buy both companies, one for my Drip portfolio, and the other for my IRA (Dell does not have a Drip, Compaq does). Compaq is selling at about where I bought it and, even though it's been only one year, I've made no money on it yet.

In hindsight, the low debt wasn't enough of a reason to buy the company. Dell was flattening Compaq in the business arena, and it's not really worth buying a runner-up.

What other financial measures am I using? Some I took right out of The Motley Fool Investment Workbook, others are standard ratios and percentages used by analysts. Here they are:

Current Ratio: Current Assets/Current Liabilities (should be high)
Quick Ratio: (Current Assets - Inventories)/Current Liabilities (also should be high)
Inventory Turnover: Total Sales/Inventories (should be high)
Inventory Conversion Period: Inventory/(Total Sales/360) (should be low)
Gross Profit Margin: (Total Sales - Cost of Goods Sold)/Total Sales
Net Profit Margin: Net Income/Total Sales (should be high)
Return on Equity: Net Income/Shareowners Equity (needs to be high)
Return on Assets: Net Income/Total Assets (needs to be high)
Debt Ratio: Total Debt/Total Assets (ideally is low)
Long-Term Debt Equity Ratio: Long Term Debt/Total Assets (needs to be low)

The Current and Quick ratios measure how well the company is keeping its debt down compared to its funds available. We go from the Current to the Quick ratios to tell us if the company's assets are tied up in inventory. We also need to look at the Inventory Turnover and Inventory Conversion Period. For example, if Compaq is making more computers than it can sell, they become tied up in inventory. It's not receiving funds to pay for the cost of manufacturing, or to use for further investment. Therefore, checking the Inventory Turnover (number of times inventory is turned over in a year) and Inventory Conversion Period (number of days in a year on average to turn inventory into cash) gives us an idea how its doing here.

It goes without saying that Net Profit Margin, Return on Equity, and Return on Assets should be high. Tom Gardner likes Net Profit Margins to be above 10%, and Gross Margins above 50%. I like to compare Return on Equity and Return on Assets of companies in similar businesses, such as Compaq to Dell. Also, I compare them year to year. They should be rising.

For the Debt Ratio and Long-Term Debt Equity Ratio, I like to compare competitors again. It's probably the only way to do this fairly, since a company like Dell will probably have to carry more debt than a company like Microsoft (Nasdaq: MSFT). Microsoft doesn't have to set up factories, or purchase raw materials, and probably needs little, if any, warehouse space. So, it's not a good measure to compare debt ratios of unlike companies. Debt isn't bad, but if the company shows debt far in excess of its competitors, or an increase of debt ratios year after year, it could be the sign of a problem.

Fortunately, these different measures are easy to put in a spreadsheet, and all you need to do is input information from the companies' annual reports. Next week, we'll take an in depth look at Dell vs. Compaq, and the week after that, Coca-Cola (NYSE: KO) vs. Pepsi (NYSE: PEP).

Call Your Boss a Fool.

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