In financial health we look at how being in a strong financial condition gives a company a number of advantages over companies with a lower measure of financial strength.
Financial health is a measure of risk that needs to be checked as part of our due diligence. It’s easy to do so let’s get started…
The importance of financial health
If we only invest in financially healthy companies, we’ll improve our chances of success. Not only that, but financially healthy companies are in a better position to achieve excellent results.
The interest payments a company makes on its loans can be a significant cost to the business. The more debt the company has, the more it has to fork out in interest payments. This higher cost means reduced profits.
Debt isn’t necessarily a bad thing. It can fund growth and enhance returns. It just needs to be kept at a reasonable level so it can controlled.
High debt means high risk. It’s a risk to profitability as the added cost of the interest payments reduce profits. And in extreme cases debt can be a huge risk to a company if the firm is forced to default (not be able to pay) on its loans.
You’ll hear investors talk about a company having a “strong balance sheet”. What this basically means is that the company has low or manageable debt levels. I also like to see that a company has substantial cash holdings (you can find this at the top of the balance sheet under current assets).
Large cash reserves can be a hedge against the company’s debts and obligations. It also means that the company is in a financially flexible position. It can use that money for all sorts of worthwhile purposes.
A company with low debt levels and lots of cash is in a highly advantageous position.
How to assess a company’s financial condition
By the time we get to our financial health assessment, we will most likely already have some idea of the company’s financial condition. By looking at sales and cash flow trends and growth rates we get an idea about how sustainable the business appears to be.
What we still haven’t determined with any surety is how stable the foundations of the business are.
We start by assessing the company’s capital structure to identify what portion of the capitalization is debt compared to shareholder’s equity. Debt is considered to be a higher risk form of funding than shareholder’s equity. The debt to equity ratio is checked first.
Debt to Equity = Long-term debt / Shareholder’s Equity
Shareholder’s Equity = Total Assets – Total Liabilities
There isn’t really a debt to equity ratio that is considered to be good or bad, but conservative investors quite often set a cut-off mark at 50%. Sometimes I’ll let the ratio go as high as 70%, depending on the company in question. As a general rule though, I don’t like ratios above 60%.
If the business environment gets tough, how easily will the company be able to pay the interest on its loans?
This is a key question. Luckily, it’s easy to answer. The Interest Coverage ratio tells us theoretically how easily (or otherwise) a company is able to repay the interest on its loans.
Interest Coverage = EBIT / Interest Expense
An interest coverage of 3 or above is considered reasonable. This means that the company’s operating income (EBIT: earnings before interest and tax) can cover the interest payments 3 times over.
- Financially healthy companies have a high degree of financial flexibility
- Debt isn’t a bad thing as long as it’s manageable
- Companies with low to reasonable debt levels and substantial cash holdings are desirable
- Continue on to Lesson 8: Management Assessment