In our Masterclass Investing this month, we show that usually an investor will consider the Financial Health of a Company they plan to be investing in, which can also determine the value of the company, and to do this the investor will look at its financial position which is based on a number of figures and ratios.
We can begin to understand what a financial health/position is, we start by using our personal situation. If you want to borrow money from a bank or lender, you will be asked to list the value of all your major/significant assets, as well as all your significant liabilities. The bank uses this information to assess the strength of your financial position, by looking at the quality of the assets – your car and your house etc, then places a conservative valuation upon them. The bank also checks that all liabilities, such as mortgage and credit card debt, are properly disclosed and fully valued. They will usually use a reporting agency. The total value of all assets less the total value of all liabilities gives your net worth, or equity position.
Evaluating the Financial Health or position of a listed company is quite similar, and investors can then take another step and consider financial position in relation to market value. You will need the company reports/statements in the Annual Report, which can be downloaded from the company’s website.
Start with the Balance Sheet
The same as your own financial position, a company’s financial position/health is partly defined by its assets and liabilities. A company’s financial position also includes shareholder equity. All this information is presented to shareholders in the balance sheet.
1. To start, the standard format for the balance sheet is assets, followed by liabilities, which gives shareholder equity – what is it and how does it compare to previous years and other companies? This is also sometimes known as Book Value, or variations are derived from different calculation methods.
Also see that the Assets and Liabilities are broken into current and non-current items.
Current assets or liabilities are those with an expected life of less than 12 months.
Current Assets include bank accounts, cash, inventories.
Current liabilities are the obligations the company has to pay within the coming year, and include existing (or accrued) obligations to suppliers, employees, the tax office and providers of short-term finance.
Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due.
2. One important ratio of current assets and liabilities that is used is the current ratio – which is total current assets divided by total current liabilities – commonly used by analysts and banks/financiers to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables or inventory. We cover examples in our Navigate Shares workshop.
Non-Current Liabilities include property, plant and equipment etc required to run the business.
Further ratios that indicate financial heath include Debt to Equity, Quick Ratio, Return on Equity, Return on Capital and many more. We also show how simple it is to calculate these in our workshop.
Then the Profit and Loss
The second report/statement companies give is the Profit and Loss or Income or Operating Statement
The Profit & Loss reports on a particular prior period, eg month, quarter, year, and shows the sales or revenue, less cost of the goods sold (if selling product), then takes away the operating expenses or overheads to show either a gain/profit, or loss. There may be unusual other income or expenses (non-operating) that are then claimable, and added or taken away after that. For example, sale of assets, events that are not part of the regular operations of the company.
3. Profit – Gross and Net, as important to the investor – what % are they? How do they compare to prior periods/years? And how are they in comparison to other companies in the same industry?
4. Interest Cover – the interest bill on loans can be compared to the profit – how many times does the profit cover the interest that is due? This is another easy ratio to look at, and consider what it shows about good financial handling
Other ways to assess financial health of a company include many other ratios and figures, as well as the Cash Flow Statement/Report.
Want to learn the core issues of share investing? Our workshop “Navigate to Successful Share Investing” gives a 2.5 hour practical session to learn to easily understand Company Financial Statements, how to find healthy companies, what tools and ratios to use, work on examples, and also includes how to get better investment outcomes. Other Bonuses as well. Check the next one see Share WORKSHOP