Imagine this: You're evaluating two companies with similarly strong sales and earnings growth. What else should you look at, to see which company might make a better investment?
One good item to examine is the balance sheet. If inventory levels or accounts receivable are outgrowing sales (in terms of percentage), that's a bad sign, suggesting that products (or parts of products) are accumulating on warehouse shelves. Another red flag would be if the company were taking on a load of long-term debt. Two companies performing similarly on the income statement can look very different on the balance sheet.
Examine the statement of cash flows, too, to see how the company's cash is being generated. Look at how much investment is required to create earnings. Generally, you want to see most cash coming from ongoing operations -- the stuff produced and sold -- and not from the issuance of debt or stock.
Also worth a closer look are the companies' margins. These include gross margins, operating margins, net margins, and the Cash King Margin. Higher gross margins can suggest that a firm has a more-proprietary brand or technology. That usually indicates a higher-quality company, with pricing power in its markets and the ability to hold down manufacturing costs.
You could also examine return on equity and return on assets, comparing companies in the same industry. See which firm is generating more dollars of earnings for each dollar of capital invested in the business. Check previous years' numbers, to see whether the trend is positive.
Basically, the more angles from which you examine a company, the better. The more information you gather, the more sure you'll likely be of your decision to invest or not to invest. For more guidance on investing and evaluating companies, read "Time to Build Wealth" and "Management Rules."
You can learn more about how to evaluate companies in our highly regarded How-to Guides and online seminars.
