Evaluating Financial Health of a Company

Evaluating financial health of a company is one of the most important aspects of stock analysis.

We offer a product which can be used to analyse stocks of companies.

It is like a comprehensive tool which can be used to judge a business based on various parameters.

Points earned by the stock on these individual parameters generates an overall grade.

The parameters based on which stocks are graded are as follows:

  • Price valuation,
  • Future growth prospects,
  • Managements efficiency,
  • Profitability,
  • Financial health,and
  • Threat to bankruptcy.

In this blog post we will see how my stock analysis worksheet is evaluating financial health of a company.

Evaluating financial health of a company

Evaluating financial health of a company is not only about net profit and its margins.

To arrive at a more reliable conclusion about financial health, one must see the business with a more inclusive outlook.

Though judging financial health is not very complicated but it needs some drilling-down.

How to do it?

One must read the companies financial statements of at least last 10 years. Oops!

Yes, this is one precondition that must be fulfilled.

Digging into financial statements of a company helps to make an accurate judgement.

For people who do not know how to read financial reports, what they can do?

My stock analysis worksheet is one such tool which can be used by such people.

This worksheet can generate few key metrics which can be used to judge financial health of a company.

Which are those metrics? This is what we will see in this blog post.

A metric which is like a perfect indicator of financial health of a company is its “profit margin level”.

But profit/profitability alone cannot define the overall financial health of a company.

One must also look at other aspects of business to judge its financial health.

In my stock analysis worksheet, the parameters that is used to judge financial health are as below:

  1. Future growth prospects.
  2. Liquidity management.
  3. Cash management.
  4. Profitability.

Based on these parameters the worksheet rates stock of a company in scale of 1 to 5.

Company scoring above 4 can be said to be financially healthy.

#1. Income growth

Over a horizon of 10 years, a decent company will display the income growth.

But what is more essential is to check if the growth has been continual (year after after).

A company which was able able to increase its income every passing year is considered good.

Even if the growth rate is not large, such companies can be tagged as financially more healthy than others.

Why? Because such continual growth in sales/income is a sign of competitive advantage.

#2. Slower expense growth

Expense growth rate in isolation may not speak as much about the company’s health.

But when expense growth is seen in comparison with income growth rate, it becomes interesting.

For any business manager, their top focus-area include the following:

  • Sales/Income growth.
  • Reduce expense.

These two focus-areas helps a company to improve both, the profit and profitability.

Sales/Income growth is what we saw in point no #1 (above).

What means by reduced expense?

It does not mean that “expense is reduced” as compared to last year.

What it really means is:

Expense growth rate should be less than income growth rate (simple).

Suppose between year 2017-2018, the income growth was 25%.

Then for a company to be tagged as financial healthy its expense growth between year 2017-2018 must be below 25%.

It is essential to check the level of expense growth, year-on-year basis.

The expense growth must be less than income-growth (year after after).

A company which was able able to keep its expense growth lower than income-growth, every passing year, is considered good.

Even if the difference is only minute, it will still improve the overall profitability of the company.

Such companies can be tagged as financially more healthy than others.

Slow expense growth rate is a great sign of competitive advantage and management’s efficiency.

#3. Cash rich company

Why a company must be cash rich?

Cash rich companies tend to continue its operations even in toughest of times.

In moments, when other companies cease to operate, cash rich companies stand-out as clear winners.

How much cash is enough?

“availability of enough cash to meet the demands of trade payables“.

What are trade payables?

It is that amount that a company owe’s to its suppliers.

Suppose there are 2 companies A & B. A owes Rs.10 million to its suppliers and B owes 100 million.

“A” has a cash balance in bank of Rs.9 million. “B” has a cash balance in bank of Rs.110 million

Which company is financially healthier?

Though B’s account payable is much higher than A, but still it is financially better placed than A. Why?

Because it has sufficient cash to meet the demand of the suppliers.

While “A” has less cash compared to the demand of its suppliers.

#4. Low debt

When it comes to fundamental analysis of stocks, debt level is one of the prime indicator of financial health of a company.

A low debt company is what all expert investors wants to see.

It may not be a debe free company, but it must be low in the following ratios:

These are such indicators which are like litmus test of debt-level of a company.

I personally like the parameter “debt minus cash”. Why? Because it leaves nothing for imagination. How?

Suppose there is a company which has following numbers mention in its balance sheet:

  • Debt = $150 Million.
  • Equity = $100 Million.
  • Cash = $150.5 Million.

What will be its Debt minus cash? Debt minus cash = -$0.5 Million.

Debt minus cash is in negative. What does it mean?

It means that the company has so much cash that it is sufficient to pay-off all debt of the company.

Such companies are as good as debt free companies.

Their other parameters are

  • Debt/Equity = 1.5.
  • Debt/Asset = 0.6.

As a rule of thumb, Debt/Equity ratio less than 1.5, and Debt/Asset less than 1 is good.

#4. Efficient utilisation of Assets

Companies build its assets over time.

The assets can be like land, building, machinery, office equipments, furnitures, vehicles, bank balance etc.

These assets in turn jointly contributes to produce goods and services.

The products and services in turn are sold by the company to generate revenue (sales or income).

The best measure of efficient asset utilisation is “asset turnover ratio”.

Asset turnover = total income/total asset.

The higher is the asset turnover the better.

Typically a value of asset turnover says how much income the company is generating per dollar of assets.

Suppose there are two steel companies (Tata Steel and JSW Steel). Lets analyse their asset turnover:

  • Tata Steel
    • Total Assets: Rs. 111,465 Crore
    • Income: Rs. 49,033 Crore
    • Asset Turnover: 43%
  • JSW Steel
    • Total Assets: Rs. 80,911 Crore
    • Income: Rs. 53,935 Crore
    • Asset Turnover: 67%

In terms of asset utilisation, JSW is a more efficient company.

#5. Inventory turnover ratio

All goods produced by the company does not get sold immediately.

After being produced, they remain in companies warehouse for some time.

Some companies are able to convert their inventory into sales faster than others.

This is what is called as efficient inventory management.

How to know which company is more efficient? By use of inventory turnover ratio.

Inventory turnover = cost of goods sold/average inventory for the period.

Lets take an example of Maruti Suzuki.

  • Cost of goods sold: Rs. 57,099 Crore
  • Average inventory: Rs. 3,197 Crore
  • Inventory turnover: 17.8

What it means by the value 17.8?

It means that, compared to its average inventory, company is selling 17.8 times over.

If Maruti has 1 number car in its inventory, compared to this it is selling 17.8 nos cars in the market.

The higher is this ratio the better.

#6. Receivable turnover ratio

Inventory turnover ratio is a measure of how fast the inventory is being converted into sales.

But for a business, there is something more important than “sales”. What is it?

Due payment collection from customers.

Generally, companies sell their products and services on credit.

This is a strategy used by businesse’s across the globe to boost sales.

Credit sales means, buyers can pay to the supplier for the purchased item after lapse of few days/weeks/months.

From buyers point of view it is good. But for a supplier, credit sales are risky.

Hence, the faster the payment is collected (after sale) the better.

How to measure if the supplier is collecting payments soon enough?

This can be done by measuring receivable turnover ratio.

Receivable turnover ratio = Net Credit Sales / Account receivables.

Suppose a company made a credit sales of $100,000 in a year.

For the same period the average account receivable (payment outstanding) was $50,000.

Receivable turnover ratio = 100,000/50,000 = 2.

What means by receivable turnover ratio of 2?

It means that, on an average, the company collects its outstanding payments twice a year.

It also means, the cash in-flow happens only twice in a year.

The higher is the receivable turnover ratio the better.

#7. Profitability

To check the profitability of a company, my stock analysis worksheet utilise following ratios:

  • PAT Margin.
  • EBITDA Margin (10Y Avg).
  • EBIT Margin (10Y Avg).

Final words…

A company which is making large lump-sum profits is not necessarily financially healthy.

Of course, net profit is one of the stronger criterias in evaluating financial health of a company.

But relying only on absolute net profit is not enough.

Apart from profit it is also important to checks other aspects of business.

The other aspects can be broadly classified as blow:

#A. Future Growth Prospects:

To check this, one must evaluate sales (income) and expense growth.

The higher is the income growth the better.

But the expense must grow at speed less than income-growth.

#B. Enough Liquidity:

In order for companies to survive, they must carry enough liquid cash.

Liquid cash is like blood flowing in the veins of a company.

If there will be no blood, the company will cease to operate.

Some companies take a short-cut route to manage their priority of “liquid cash”.

What is the short-cut? Availing too much debt.

A company which is drowning in debt cannot be financially healthy.

Hence my stock analysis worksheet use the debt/equity ratio to quantify if the company is relying on too much on debt.

Another financial metric called Debt/Asset ratio can also be used to identify if company is debt ridden or safe.

My worksheet use another metric called “debt minus cash”. What is this?

Please read #4 above to know more about it.

[Read: Enterprise value of companies]

#C. Efficient Cash Management.

We have seen that, cash is like blood for a company.

But it is equally important for this blood to keep flowing in the veins of the company.

This is what is called as “cash flow”. How cash flows in companies?

  • Cash-in: Customers must pay on time.
  • Cash-out: Employees, suppliers etc must get paid on time .

Though it may sound simple, but in real life, this is one of the biggest challenge for any company.

Proper cash flow will happen only when the whole business process is efficient.

How to measure if the process is efficient or not?

By use of the following 3 ratios:

  • Asset Turnover Ratio
  • Inventory Turnover Ratio
  • Receivable Turnover Ratio

#D. Profitability:

No company can be said to be financially healthy till it has not maintained a reasonable profitability.

A highly profitable business has less chances of seeing bad days (closure etc).

A company which has following collective attributes can be said to financially healthy:

  1. High future growth prospects.
  2. Maintains sufficient liquidity.
  3. Maintains an optimum cash flow.

Has high profitability.

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