What makes a good company?

A few ‘financial advisers’ I know have a shaky understanding of the relationship between balance sheet and income statement, and are really just money brokers helping their clients find funds, jobs and resources. Sometimes, they show me the financial statements of a client of theirs – in the hope that I will reassure them the business is a good one, worth their time and effort – but these documents are typically so awful I can’t imagine them interesting any investor.

There is a general truth in play here: a business’s financial figures are crucial to an investor’s disposition to invest. It’s what makes those of us who help companies prepare their financial statements potentially the best financial advisers of all.

Liquidity

During one consultancy assignment, I recall being shown a set of financials where, going by the income statement, the company was no slouch, as it reported substantial profits. However, a look at its bank balance revealed a very different state of affairs. There was a worrying distance between the cash balance the company was sitting on and the scale of the business. Naturally, I gave its receivables and payables a thorough going-over in case the problem was oversized or long-ageing receivables were creating cashflow backlogs.

Then there was the specialist company that makes equipment for oil drilling offshore, each costing something between 10m and 20m yuan. Orders pile in steadily, but there are protracted delays in collecting the money, as most are bought on credit. Settlement is so slow that the company has only recently been paid for an order placed in 1998. Given the time value lost, the company founders must have burst into tears when it was finally settled.

A profitable company is not necessarily a ‘good’ one. My fitness trainer once told me I should take more care about my body shape than my weight. Of course, he may simply have been criticising my shape, but the rule holds true for business too.

Profit model

Many investors care more about the business model than the profit model. The internet industry, for example, believes once there is enough traffic, profit will surely follow. Many companies will tick the boxes on business model, yet their profit model may have a ‘congenital defect’ that makes profit very difficult or impossible to deliver.

For example, some online ride-hailing platforms and celebrity dining companies have struggled to make a profit even though they benefit from a certain level of ‘monopoly’. Without a proper business model, their less successful peers survive only through sheer luck.

A couple of weeks ago, I went to review a beauty clinic. It appeared to have a high gross margin (if only fixed costs were considered) but also paid a shockingly high commission for referrals. Companies with high variable costs can easily become loss-making; deductible expenses increase sharply as the business grows. The bigger the market size such a company achieves, the more loss it is likely to incur.

Leverage

In financial analysis, the asset-liability ratio is a key metric. If that ratio is 100%, it means all assets are being funded by debt. But some assets, such as receivables, are not assets in real terms – factor in impairment and uncollectibles, and the company may already be insolvent. In general business sectors, a decent company should keep its asset-liability ratio below 50%. Many property developers have a high debt ratio, and you can see them paying the price now.

I had intended to add a few other criteria to this list of key business measures – the team, market track, corporate culture, organisational structure, business sector, and so on. But on second thoughts, I decided they really don’t matter that much if a company’s financial condition deteriorates too far. Everything else is illusion.

In a nutshell, the criteria covered here – liquidity, profit model and leverage – are all about money. First, a company should do its best to keep money coming in. Companies that are complacent about the red lines are hooligans. Second, once a company can make money, it must do its best to capture it. A business is not a charity. Third, try to use your own money, and consider leverage wisely. However much you’re able to borrow, you still have to pay it back sooner or later.

If you understand all this and have put it into effect at your business, then you’ve earned yourself a red flower – that very Chinese symbol of good fortune, success and prosperity – because your company is indeed a good one.