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Finanical Statement Analysis for Investors - Part 2
Course Section 3 - Lesson 5
Now that we've learned a bit about the type of information we can find in financial statements, I want to walk through some real-world examples of how we might utilize this information. In the second part of our financial statement analysis lesson, we're going to look at review the financial statements of Texas Roadhouse and try to answer the following questions:
How strong is the company's financial position?
How consistently has the company grown, and what do I expect growth to look like in the future?
How stable are the company's margins, and are there opportunities for margins to expand?
Is the company maintaining its fixed capital (i.e., build/equipment/etc.) so that it's on solid ground for future growth?
For this lesson, I will be referring to tables that are pulled directly from my free tikr.com account. Also, Tikr has a great feature that allows you to copy financial statements and paste them straight into google sheets or Excel for easy manipulation.
Evaluating Financial Position
Assessing the strength of a company's financial position begins on the balance sheet. What we want to know is:
How much leverage, or debt, has the company taken on?
Is it able to comfortably support the debt that it has?
Will the company be able to meet its near-term cash needs?
And has there any recent changes to any of the above?
To answer these questions, I'll begin by looking at the company's balance sheet over an extended period, say ten years.
Before I dive directly into the questions, I first want to understand how the company has grown. To do this, I simply pull the top-line for Assets, Liabilities, and Equity into a spreadsheet and calculate the year-over-year change. When I'm done, it looks something like this:
When I look at this graphic, two things jump out.
I like how consistent growth has been, especially in the assets and equity sections of the balance sheet. It's indicative of a healthy growing company.
There has been a giant jump in liabilities into 2019 and 2020. The increase is worrying, and I need to understand what was driving this.
I decided to dig into to point number two immediately and figure out what was going on. After some research, it turns out that the lion's share of the increase in liabilities results from a change in accounting standards for how companies must report property leases. This change in standards didn't fundamentally change the business or the amount of risk the company was taking. For now, I'm not worried about this liability spike.
How much debt does Texas Roadhouse have?
Once again, I've carved out a specific portion of the balance sheet to better understand the company's long-term debt.
At first glance, it looks like debt has skyrocketed recently. As we looked at a moment ago, the capital leases have always been there; they just haven't required reporting previously. The $190 million in debt in 2020 is new, and it is far greater than the $50 or so million that the company has carried historically. After some research, I found this in the company's 10K:
Given the pain that the pandemic has caused the restaurant industry, raising $190 million in cash seems like a prudent precaution for the company to take. While the company will have to pay interest on the loan, the interest payments are more than offset by the safety the cash provides during an uncertain period. Given that this is the only true debt the company has, I'm comfortable with this decision.
The last two things that I look at are the proportion of debt to assets for the company and how many times the company's earnings could pay its interest payments, also known as interest coverage (Earnings before Interest & Taxes / Interest Expenses).
The company's debt to assets ratio is currently at 60%; once this ratio climbs above 50%, a company can be considered highly leveraged. This is higher than I would like to see for a company that I invest in. However, three things give me comfort.
The bulk of the company's debt is due to leases, which can be renegotiated or exited during difficult periods.
The company's interest coverage ratio is over six times, which is perfectly acceptable.
About 25% of the debt was raised as a pandemic safety net. Given the trajectory of the pandemic, it's reasonably likely to be paid back soon.
Overall, I'm comfortable with Texas Roadhouse's financial position.
Assessing Growth and Setting Expectations
When we refer to growth, we are referring to 1 thing - revenue growth. We want to know how quickly a company can sell more stuff. One line item, in particular, provides insight into the company's growth record, that is, the total revenue line item on the income statement.
Texas Roadhouse's record is impeccable. For the last decade, the company has grown total sales by more than 10% each year, excluding the pandemic. In fact, the company's track record of solid growth goes back a lot farther than 2011. This is precisely the type of consistent growth that you love to see as an investor.
Of course, this level of growth can't continue forever, or eventually, there will be a Texas Roadhouse on every block in the United States. However, we can look for clues for how much runway the company has left. These clues can't be found in the financial statements, however.
At this point, it is necessary to make a judgment call about how many Texas Roadhouse restaurants the market can support. Given that there are currently 875 Olive Garden locations in the US, I'm confident that there is still a lot of room for Texas Roadhouse to expand its 611 locations. Still, even if the restaurant hits its target of 25-30 new locations per year, that only equates to about 5% revenue growth due to new locations. If we add another 2-3% for inflation-based menu price increases, we should expect to see about 7-8% growth in revenue for at least the next five years. That's very strong, but not quite the double-digit growth seen in the past.
Before digging into margins, I want to take some time to explain what they are. Margin, or profit margin, is the amount of profit that each sale generates. If you sell a sweater for $100, but it costs $40 to make the sweater and $20 to market and sell it, then your margin on the sweater sale is $40 ($100 - $40 - $20 = $40). Because comparing products with different selling prices can be difficult, margin is usually expressed as a percentage of sales. In this case, we can easily convert the $40 profit margin to a percentage by dividing by the sales price, $100, to determine that our profit margin on every sweater sale is 40%.
Profit margins come in a few different flavors. You will see management and analysts discussing gross margins, operating margins, and net margins when discussing their operations. Each type of margin refers to a specific point on the income statement.
Gross Margin is the highest level of margin, and it refers to the profit that exists after deducting costs that are directly attributable to the sale of the product. This measure provides a sense of profit each additional sale generates for the company.
Operating margin is the second-highest level, and it refers to the profit that exists after deducting directly attributable costs and the indirect costs required to run the business. These would be items such as marketing, rent, employee expenses, etc. This measure provides insight into how much profit the company generates.
Finally, net margin is the lowest level, and it refers to profit that is available after deducting direct and indirect costs, as well as interest and tax payments. This final measure gives investors a sense of how much of each sale remains for them after the payment of all expenses.
Obviously, higher margins are better. But as investors, we also care about margin stability and the potential for a company's margins to expand.
Texas Roadhouse exhibits very stable margins. Aside from the most recent period, which includes the Covid-19 pandemic, gross, operating, and net margins have only fluctuated by a percentage point or two.
Because margins have been so stable historically, unless we anticipate a change in the environment for restaurant operators, it's reasonable to assume that margins will remain roughly the same going forward.
Ensuring Fixed Asset Maintenance
Nearly every company relies on fixed capital to run its business. It could be a factory, a warehouse, equipment, or any other assets that are integral to the company's operation. These fixed assets are typically expensive, and they require upkeep if the company expects to continue using them indefinitely.
It can be tempting for a company's management team to forego the expenses necessary to maintain and upgrade these assets. Ignoring such costs would make the company more profitable today, at the risk of potentially ruining the company in the future.
Before we invest in a capital-intensive company, we want to ensure that the management team is allocating resources to maintain the companies assets.
We can do this through an examination of the statement of cash flows. Within that statement is a line item titled "Capital Expenditures" in the Cash from Investing section. I've broken out that line item on a year-by-year basis for the last decade below.
While annual expenditures do bounce around a bit, we see two strong signals that management is taking care to maintain its fixed capital. First, yearly capital expenditures tend to be around twice the company's annual depreciation expense. Depreciation represents an estimate of the dollar value deterioration of capital assets. Second, on average, capital expenditures are growing at between 8-10% each year, right in line with the company's sales growth.
Usually, companies will provide further detail around their capital expenditures in their 10K filing and Texas Roadhouse took this step. As I was reading the filing I came across this table:
Again, this reinforces my belief that management is taking care of their capital.
Spending Time with Statements
While I attempt to cover some of the highest impact components of financial statement analysis in this lesson. This type of analysis is a very deep subject. There are many great books on conducting a thorough analysis of a company's books, and I recommend that you make time to read more on the subject. However, don't let the fact that you are not yet an expert stop you from diving in.
10K's and 10Q's along with their accompanying financial statements are written in a way that allows laypeople to understand a business and the results of its operations. You will have to take notes while you read and google terms you are unfamiliar with, but you will learn a lot in the process, both about your company of interest and how to better read these documents.