Whether for your SMSF investments or not, investors want to know how to determine a healthy company, that is, the financial health, as it helps investors (either those buying shares in listed and other companies, or business owners in their own companies) to be confident that the investment is worthwhile or going as expected, or improving or declining (which means it’s time to exit!).
Generally, a healthy company, financially, can be summarised in 4 main areas –
liquidity, solvency, operating efficiency and profitability.
And out of the 4 main areas, possibly the best measurement of a healthy company is the level of its profitability.
Investors and business owners often search for one key measurement that can be obtained by looking at a company’s financial statements for evaluating a stock or their business, but one is really not enough. To efficiently evaluate the financial health and long-term sustainability of a company, a number of financial ratios must be considered, the same as blood pressure doesn’t tell if there is diabetes or cancer – other tests reveal different elements.
There are a multitude of financial ratios that can be used to gauge a company’s overall financial health and determine the likelihood of the company continuing as a viable business. Single numbers such as total debt or net profit are less meaningful than financial ratios that connect and compare the various numbers on a company’s balance sheet and profit and loss. The general TREND of financial ratios – whether they are improving or declining over time, is the most important consideration, as well as comparisons to the ratios of general businesses in your industry.
Let’s look at one or two main ratios of each main area of a healthy company –
Liquidity is a key factor in assessing a company’s basic financial health. Liquidity is the amount of cash and “easily-convertible-to-cash” assets a company owns, to manage its short-term (current, in 12 months) debt obligations.
The two most common metrics used to measure liquidity are the current ratio and the quick ratio which takes out inventory. Generally, a current or quick ratio lower than 1.0 is a danger signal, as it indicates current liabilities exceed current assets. Two is the preferred level for plenty of buffer.
Similar to liquidity is solvency, a company’s ability to meet its debt obligations on an ongoing basis, not just over the short term. Solvency ratios calculate a company’s long-term debt in relation to its assets or equity.
The debt-to-equity (D/E) ratio is generally a solid indicator of a company’s long-term sustainability, because it provides a measurement of debt against stockholders’ equity, and is therefore also a measure of investor interest and confidence in a company. A lower D/E ratio means more of a company’s operations are being financed by shareholders and is low by creditors. This is positive for a company since shareholders do not charge interest on the financing they provide.
D/E ratios calculations vary widely between industries, but regardless of the specific nature of a business, a downward trend over time in the D/E ratio is a good indicator a company is on increasingly solid financial ground.
A company’s operating efficiency is key to its financial success. Its operating margin/profit is the best indicator of its operating efficiency. This shows a company’s basic operational profit margin after deducting the variable costs of producing and marketing the company’s products or services; but is also an indication of how well the company’s management controls costs.
While liquidity, basic solvency and operating efficiency are all important factors to consider in evaluating a company, the bottom line remains in the company’s bottom line: its net profitability!. Companies can survive for years without being profitable, operating on the goodwill of creditors, loans and investors, but to survive in the long run, a company must eventually attain and maintain profitability.
The best metric for evaluating profitability is net margin, the ratio of profits to total sales/revenues. It is important to consider the net margin ratio because a simple dollar figure of profit is inadequate to assess the company’s financial health. A company might have a net profit figure of a hundred million dollars, but if that dollar figure represents a net margin of only 1% or less, then even the slightest increase in operating costs or marketplace competition could plunge the company into the red and possible difficulty. A larger net margin, especially compared to industry peers, means a greater margin of financial safety, and also indicates a company is in a better financial position to commit capital to growth and expansion.
Want to learn the core issues of share investing?
Our slides SMSF & Shares Overview gives a quick 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.