How to Make Sure Your Shareholdings Don't Get Carried off on a Stretcher!
June 29, 2017
*Before I proceed, on Tuesday I will be announcing, with great honour and excitement, the WINNER of the prestigious 2016/2017 ASX Brownlow Medal. The Best and Fairest stock on the market*
Every investor needs their own process to undertaking what the AFL industry refers to as a, "medical". You will be needing quite a few green whistles to alleviate the pain without one, for more than one reason.
Injuries are part of our great game. Luck plays a significant part. They can unfortunately cripple careers and turn players, who would otherwise be great contributors, into liabilities for their football clubs.
The amount of due diligence undertaken by club medical specialists these days is enormous. They want to ascertain whether a future investment is prone to chronic re-occurring injuries. Medical files of parents are studied, especially if they too were athletes, stress tests are undertaken and even surgeons are interviewed. With some sophisticated due diligence, AFL clubs can reduce the probabilities of recruiting a player that who is chronically susceptible to injury. The medial is a screening process.
I introduce to you my own ASX Medical. A process for determining whether a company fundamentally fit and healthy. There's only one place you need to go and that is the company's balance sheet. A balance sheet, also known as a statement of financial position, provides a snapshot of how financially healthy a company is at a specific point in time.
It indicates what the company owns, 'Assets', and what it owes, 'Liabilities'. There are two types of assets. 'Current assets' - assets that can be liquidated within 12 months, and 'non-current assets' - assets that cannot be easily disposed of. There are also 2 types of 'Liabilities'. 'Current liabilities', debt that needs to be paid within 12 months, and 'non-current liabilities', or longer term debt. The difference between a company's assets (current + non-current) and liabilities (current + non-current) is known as shareholder equity.
Some AFL players tend to fail medical examinations due to re-occurring injuries or hereditary reasons, especially if the players parents were athletes. The common denominator among companies that fail the medical is an excessive amount of debt on their balance sheet.
A healthy amount of debt can be a good thing. Debt allows companies to grow and expand their operations a little quicker than what they otherwise would. Too much debt though is a problem. It doesn't leave much of a buffer if the company was to experience slowing revenue or earnings. If you have a mortgage, imagine the stress it would cause if your income dropped 30%.
So what are the financial health ratios to look out for and how much debt is good debt?
Current Ratio - The current ratio measures a company's ability to repay its short-term debt or bills using its short-term assets. Not being able to pay short-term bills, such as an interest repayment, usually leads to trouble. It's calculated by dividing current assets over current liabilities. The higher the figure the better. As a general rule of thumb, a current ratio of 1 or 1.5 shows that the company can meet its short-term debt obligations.
Quick Ratio - This is sometimes known as the 'acid test'. It excludes the dollar value of inventories from the current assets figure, providing an indication of whether the company would meet its short term obligations if there weren't any buyers for their product. Think of it as going through a rigorous fitness test on the eve of the grand final after dislocating your shoulder the previous game, like Mick Malthouse in 1982 who missed out on selection.
Interest Cover - This is expressed as a ratio and illustrates a company's ability to cover the interest payable on its loans from its current earnings. It is calculated by dividing the company's EBIT (Earnings Before Interest and Tax) by the interest payable on loans. The higher the figure the better. An IC ratio of less than 1 indicates a loss-making and unhealthy business. This is particularly relevant for growth stocks, some fall into the rap of growing too aggressively.
Net Debt-to-Equity ratio - this is measured in percentage terms and is a basic measure of how much debt a company has compared to the amount of money it has raised from shareholders. It is calculated using the following formulae: Long term debt / shareholders' equity x 100. For example, a really healthy debt-to-equity ratio is 20%, a company has borrowed $20 for every $100 it has raised from investors.
It's worth noting that some players, like stocks, can suffer severe injuries year after year, and still turn out to be solid investments in the long term. Think Daniel Menzel from Geelong, who after suffering 4 knee reconstructions is now a fantastic contributor. Alex Johnson has recently returned after suffering an unimaginable 5 reconstructions. These are very special types of investments that posses characteristics that not many others have.