The Financial Health of a company is measured by many factors, (or financial ratios) not just one or two. It involves a minimum of a dozen ratios (calculations comparing one value to another). For example the amount of debt (debt divided by equity = debt to equity ratio), the growth in sales, growth in earnings (profit), strong cash flow (cash left after expenses, equipment maintenance, debt and dividends), return on assets, return on equity etc.
Commonwealth Bank tells us financial ratios help you to measure where your business stands, where it’s been and where it’s heading. They also help you measure yourself against industry benchmarks, and see how you’re tracking against your business plans.
Com Bank have 5 top ratios (among others) they consider their top ones, namely Gross profit margin, Net profit margin, Current ratio, Inventory turnover, and Return on owner’s equity
Lincoln Indicators have developed their software Stock Doctor (no affiliation or commission), which has a Financial Health model developed from Dr Merv Lincoln’s extensive academic research into the relationship between key accounting ratios and insolvency risk. Commissioned by the major banks, Dr Lincoln developed a unique combination of ratios to identify potential insolvency risk after analysing thousands of companies that failed compared with those that succeeded over three economic cycles encompassing almost ten years.
Although developed 25 years ago, Merv’s son Tim put his method into software (Stock Doctor), and the method and ratios were recently tested and refined under the guidance of Associate Professor Neville Norman, the Financial Health model is just as effective today as it was when developed more than twenty years ago. In fact, recent research confirms Stock Doctor’s Financial Health methodology accurately identified more than 95 per cent of failed businesses before they went bankrupt.
What Stock Doctor gives as a starting point, is Financial Health, a model that assesses key accounting ratios relating to each company’s profitability, cashflow, liabilities and assets. It then determines a Financial Health score commensurate with the business risk of the company so you can quickly identify stocks that warrant further consideration and eliminate those that don’t.
Some more information and examples are given at Waelsasso’s blog. He explains “Financial ratios are used to analyze trends, a standalone ratio tells very little about a company – it needs to be related/stood alongside a refernce. You would never hear a worthwhile business person only say “I did well this year as my company generated a profit margin of 10%”, what he would say “I did well this year as my company generated a profit margin of 10% compared to 3% last year” or “compared to 5% industry average” or “compared to 8% budgeted for the year”.
We use Stock Doctor and Conscious Investor, two software that were academically developed over 15-20 years, and teach our clients about investing in their self managed super funds. If you would like to know more and come to a free educational seminar, contact us.