Continuing with the series on the comprehensive investment checklist adapted from Michael Sheen’s book “The Investment Checklist”, this section looks into the questions asked regarding the distribution of earnings and cash flows.
You can find sections one through five in the links appended below.
Part One – click HERE.
Part Two – click HERE.
Part Three – click HERE.
Part Four – click HERE.
Part Five – click HERE.
27. Are the accounting standards that management uses conservative or liberal?
Accounting standards can make a big difference in how revenue and/or expenses are recognised in the income statement.
In particular, revenue recognition techniques allow some leeway on how companies should recognise revenue.
Conservative methods generally try to play down revenue recognition and ensure proper recognition of expenses, and are a hallmark of prudent accounting.
The liberal use of the same standards results in aggressive and early recognition of revenue or gains and downplays expenses and costs.
Here’s the rub.
Although both methods are legal, investors may wish to gravitate towards more conservative practices as these display a more accurate picture of how the business is performing.
28. Does the business generate revenues that are recurring or from one-off transactions?
Some businesses generate sales through “batches” or contract-based transactions.
These types of sales end up being more “lumpy” and are not as consistent as businesses that report recurring sales.
As an investor, we should be wary of contract-based type businesses as constant bidding needs to be done to secure orders.
One-off transactions can deliver a big “spike” in revenue but these may be tough to replicate in the future.
29. To what degree is the business cyclical, countercyclical, or recession-resistant?
Businesses which are very sensitive to business cycles are termed “cyclical”.
“Countercyclical”, on the other hand, refers to a business that will thrive when there is a downturn.
Cyclical companies tend to enjoy sharp boom and bust cycles and can be risky to invest in if you do not understand how the economic cycle works.
Countercyclical and recession-resistant businesses are those which continue to do fairly well despite downturns, examples of which include the healthcare and education industries.
30. To what degree does operating leverage impact the earnings of the business?
Operating leverage describes a situation where economies of scale help to lower the cost per unit of production for a manufacturing business.
Thus, when the business scales up its production volume, costs do not rise proportionally and it enjoys better margins as a result.
Such businesses usually have a large proportion of fixed costs, thus they can enjoy a significant lift in profits once they begin selling more.
The converse is also true, however.
If a business has mostly fixed costs, it would be unable to eliminate this layer of costs when sales or orders fall drastically.
Therefore, operating leverage can cut both ways.
31. How does working capital impact the cash flows of the business?
Working capital represents the flow of resources and money which sustains a company’s business and involves a mix of payables, receivables, inventories as well as cash.
In the same vein, some businesses may require higher levels of working capital to function.
For instance, their cash may be used to finance large projects which do not pay off immediately.
Other types of companies may be asset-light or may not carry inventory (e.g. services companies).
These companies will not require high working capital requirements.
The general rule is that the more working capital a business needs, the more cash will be tied up and may not be readily available for other purposes such as paying dividends or doing share buy-backs.
32. Does the business have high or low capital expenditure requirements?
Businesses that require massive amounts of cash to sustain their operations are described as high-capital-intensity firms.
Capital expenditure, or capex, is defined as spending made by a company to both maintain its competitive edge and expand or grow its business.
Asset-light companies normally would require less capex unless they engage in a lot of research and development.
The capital intensity of a business would usually determine whether it can generate consistent free cash flows.
Investors should target businesses which have a history and track record of sustainable free cash flows as these usually end up being more resilient during downturns.
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Disclaimer: Royston Yang does not own any of the companies mentioned.