The most important financial ratio to use to avoid investing in bad businesses and potential fraudulent companies.
Is there such ratio?
Yes, there is!!
It’s called Quality of Earnings (QoE)!
And it’s defined using the formula below:
This ratio simply tells investors how much cashflow will the company receive from its customers for every earnings the company makes.
So, why is it so important?
1) Distinguish good businesses from the bad ones
Cash is the King!! Cash is the lifeblood of a company. Without it, the company will go down in no time.
We must first understand that for every profit a company makes, it wouldn’t translate into an actual cash inflow for the business based on the credit terms offered to customers. Of course, the credit period varies as it depends on the nature of the business and the industry.
Our benchmark for QoE is ≥0.8x. Which means, the company should at least receive 80% of their profits back in cash to be considered a decent company. If a company consistently receives less than that from their customers, it shows that the company have limited bargaining power with their customers, who would keep dragging and delaying their payments. This is not a healthy sign for any businesses; thus, investors should always avoid investing in such businesses.
2) Avoid potential fraudulent companies
Many investors focus on earnings when making investment decisions. On top of that, many management’s remuneration is closely tied to the company’s earnings performance. Therefore, the management have lots of incentives and motivations to artificially jack up earnings.
While there are various methods that’s relatively easier for management to artificially jack up company earnings, it is more difficult for them to manipulate cashflow as all the cashflow movements are recorded in the bank statements.
When a company reported a huge earning increase, at the same time, the cashflow doesn’t flow in accordingly, the QoE will be low. This makes the source of earnings questionable. While we can’t confirm that the company is fraudulent, and it’s not our job as an investor to determine whether they are fraudulent anyway, we should always avoid investing in such businesses.
In conclusion, if a company demonstrates QoE of less than 0.8 consistently for the past 5 years, it doesn’t matter whether it’s fraudulent, or just purely poor business nature, we as an investor shouldn’t put much time and effort in it.
Positive Case Studies:
Negative Case Studies:
This article was written by Team VIC
Team VIC is formed by experienced and well-trained individuals from Value Investing College (VIC). The team has been consistently studying the latest stocks market trend in order to focus on educating the layman on investment principles and techniques.