The 10 Questions You Have to Answer Before You Buy Any Stock — Part 3

So far in this series, I have shared the first seven of 10 questions that you should answer before you decide whether or not to buy a share of stock in a particular company. If you missed that guidance, I encourage you to check out my previous columns: part 1 and part 2. You may want to review those questions because the next three build on their answers.

The questions addressed thus far are:

1. What does the company do?
2. What are its key products or services?
3. At what business unit or units does the company make most of its profits?
4. Who are the key competitors and how are they impacting the market?
5. What is driving growth at the company?
6. What is driving the company’s profit picture and, if it’s not improving, why is that?
7. What does the company’s balance sheet look like?

The gist of these 10 questions is to help you understand the company you are investing in and items to pay attention to when sizing up what’s on the horizon, both good and bad. After all, how do you know how to gauge a company’s business and the competitive landscape if you don’t have a firm understanding of what the company does and how it makes money for itself and its shareholders? These are some of the tools I use each time I look at a new opportunity that I may share with subscribers to my Growth & Dividend Report newsletter.

Here are a few things to consider once you’ve looked at both the cash and debt levels: first, what is the net cash position per share and how does it compare to the company’s stock price? Let’s break that down a bit, shall we?

Net cash per share = (total cash – total debt)/shares outstanding

If we look at its March 2015 quarter financial statements, Procter & Gamble (PG) had $13.16 billion in cash, total debt of $32.439 billion on its balance sheet and 2.88 billion shares outstanding. Using those figures, at the end of that quarter:

PG’s net cash per share = ($13.16 billion – $32.439 billion)/2.88 billion

PG’s net cash per share = (-$19.279 billion)/2.88 billion

PG’s net cash per share = -$6.69

I do have to point out that if a company has more debt than cash on its balance sheet, and there are companies like Procter & Gamble and hundreds of others that fall into this category, you will see a negative net cash per share figure. All that means is they have more debt than cash. In PG’s case, every share carried around $6.70 in debt at the end of the March quarter — that’s about 8% of the company’s current stock price. I will have more on that when we get to Question 8 in my next column.

Depending on the business and its cash generation, higher debt than cash levels could be nothing major or it could be something that could cause you to strike the company from your stock shopping list.

Think of a person who has racked up so much debt — possibly from credit cards or something else — that at the end of each month they find they have no money left over once they’ve paid all their bills, including the interest on all that credit card debt. If they can’t meet those minimum monthly payments, and we’ve all run into a person or two in our lives that has fallen into this situation, in Wall Street speak, they lack proper debt coverage. That is, after all their monthly expenses (rent, utilities, car payment and so on) and the interest payment on their debt (those credit cards), they either have little funds for anything else or they lack sufficient funds to pay the interest all together. It is not a fun place to be at all.

When we look at a company’s balance sheet, we want to determine if it can handle the interest payments (interest expense on the income statement) and still invest in its business (capital spending, research & development) so it can continue to grow (new products, new markets, geographic expansion and so on).

The quick way to determine how easily a company’s business can handle its interest payments is to examine what we call its “interest coverage ratio.” I know, it means doing more math, but we want to make sure we are avoiding a company that could fall into trouble down the line so a few minutes of math is more than worth it.

We determine a company’s interest coverage ratio by using some information on its quarterly income statement as follows:

Interest coverage ratio = Operating profit / interest expense

The higher the coverage ratio, the more easily a company can handle its interest expense payments. As you look at different companies and perform this quick calculation, a good rule of thumb is to steer clear of those companies with an interest coverage ratio of 1.5 or lower because they could be hard pressed to meet interest expense payments if things get a little difficult (economic slowdown or a recession). Should you encounter a company that has an interest coverage ratio below 1.0, my recommendation is to avoid it like the iceberg that hit the Titanic. In other words, steer clear as fast as possible — there simply are too many other companies out there that offer better prospects.

Let’s take another look at Procter and Gamble. In that same March 2015 quarter, the company’s operating profit clocked in at $3.45 billion and its interest expense for the period was $149 million. Applying our interest coverage ratio formula:

Interest coverage ratio = Operating profit / interest expense

Interest coverage ratio = $3.45 billion / $149 million

Interest coverage ratio = 23

Procter and Gamble has more than sufficient interest rate coverage, which you might have suspected given how we have to replace all of its products, which typically are consumables, every few weeks or every few months.

As you can see, a company’s balance sheet offers a fair amount of insight into the financial health of a company. While we all like to talk about revenue and earnings per share, the balance sheet is not to be ignored.

After re-reading all of the above myself, I realize that’s quite a bit to chew on this week. As tempted as I am to push on to discuss Questions 8-10 in this column, as a good professor I know when to call it quits lest we overload our brains with too much information.

I’ll be back next week to continue The 10 Questions You Have to Answer Before You Buy Any Stock. Watch for my next column then!

In case you missed it, I encourage you to read my e-letter column from last week, which explored the sixth and seventh questions on our list of ten questions to answer before you buy any stock. I also invite you to comment in the space provided below my commentary.