EP.4 – A company’s financial health

EP.4 – A company’s financial health

The financial health of a company is a comprehensive assessment that determines how well the company is performing financially and its ability to sustain operations, meet obligations, and expand. The evaluations are crucial not only for assessing current performance, but also for predicting future performance. As with a medical check-up for businesses, financial health checks identify potential financial illnesses before they become severe; they diagnose financial robustness. In order to make an investment decision, investors need to understand a company’s financial health. The company’s management uses it to plan strategically and adjust operations. For investors, it assists them in determining whether a company is a safe bet, potentially profitable, or a risky investment. In the balance sheet, the company shows what it owns and owes; in the income statement, the company shows how much it has earned and spent over a period; in the cash flow statement, how changes in the balance sheet and income affect cash and cash equivalents.

1. Balance Sheet

Balance sheets are financial statements that show the assets, liabilities, and shareholder equity of a company at a given point in time. Besides providing a snapshot of the company’s assets and liabilities, they show how much shareholders have invested. Assets are resources owned by the company that are expected to bring economic benefits in the future. Liabilities represent future claims against the company’s assets that the company must settle in the future. After subtracting liabilities from assets, shareholders’ equity represents the owners’ claims.

  • Understand the Structure:
    • Assets: These are resources owned by the company that are expected to bring future economic benefits. Assets are typically divided into current assets (cash and other assets that are expected to be converted to cash within a year) and non-current assets (long-term investments, property, plant, equipment, and intangible assets).
    • Liabilities: These are obligations the company owes to outside parties. Liabilities are also split into current liabilities (due within one year) and long-term liabilities (due after one year).
    • Equity: Also known as shareholders’ equity, this represents the owners’ claims after all liabilities have been settled. It includes capital stock, retained earnings, and possibly treasury stock.
  • Analyzing Assets:
    • Current Assets: Check items like cash, inventory, and receivables. High amounts of cash and easily liquidated assets are good signs, but excessive inventory may indicate sales issues.
    • Non-current Assets: Long-term investments, property, and equipment. Stability in these accounts is typical, but large investments or disposals can impact financial health.
  • Analyzing Liabilities:
    • Current Liabilities: Includes short-term borrowings, accounts payable, and other short-term financial obligations. Rising current liabilities may indicate a struggle to cover short-term obligations.
    • Long-term Liabilities: Look for stability in long-term debts like bonds payable or long-term lease obligations. Increasing long-term debt may raise concerns about long-term financial health.
  • Analyzing Equity:
    • Share Capital and Reserves: A stable or increasing share capital and reserves indicate good financial health and investor confidence.
    • Retained Earnings: An important indicator of financial health; it shows how much profit the company has retained over time. Consistent growth in retained earnings typically signals good profitability.

Key Indicators of Financial Health from a Balance Sheet:

  • Liquidity Ratios:
    • Current Ratio (Current Assets/Current Liabilities)
    • Quick Ratio (Liquid Current Assets/Current Liabilities)
  • Solvency Ratios:
    • Debt to Equity Ratio (Total Liabilities/Shareholders’ Equity)
  • Profitability Ratios:
    • Return on Assets (Net Income/Total Assets)
    • Return on Equity (Net Income/Shareholder’s Equity)

Example
The balance sheet of a strong company would typically show a healthy asset-to-liability ratio which provides the company with a solid foundation to weather economic declines and invest in growth. Having a strong balance sheet allows the company to take on debt when necessary and to take advantage of investment opportunities. It can also help attract potential investors, as a strong balance sheet is a sign of financial health.

2. Income Statement

Income statements are also known as profit and loss statements and summarize a company’s revenues, expenses, and profits or losses over a specific period. They illustrate how revenues become net income or net profit. Revenue (sales), costs of goods sold, gross profit, operating expenses, and net income are the main components of this report.

  • Understand the Structure:
    • Revenue: Often reported as the top line, it includes the total earnings from normal business operations. It’s crucial to differentiate between gross revenue and net revenue, where net revenue accounts for discounts and returns.
    • Cost of Goods Sold (COGS): Direct costs attributable to the production of the goods sold by the company. Subtracting COGS from revenue gives the Gross Profit.
    • Operating Expenses: Includes selling, general, and administrative expenses (SG&A), depreciation and amortization, and other operating costs that are not directly tied to production.
    • Operating Income: Also known as Earnings Before Interest and Taxes (EBIT), this is calculated by subtracting operating expenses from gross profit.
    • Interest and Tax: Interest expenses from debts and tax obligations that are deducted from operating income.
    • Net Income: The bottom line or net earnings calculated after subtracting interest and tax from operating income. This figure shows the company’s profit after all expenses have been deducted from total revenue.
  • Analyzing Revenue:
    • Revenue Growth: Look at the year-over-year (YoY) and quarter-over-quarter (QoQ) growth rates. Consistent revenue growth is a good indicator of expanding business operations and market acceptance.
    • Revenue Sources: Understand the diversification of revenue sources to assess reliance on specific products, services, or markets, which can imply risk if too concentrated.
  • Analyzing Expenses:
    • COGS and Gross Margin: Monitor the gross margin (gross profit/revenue). A declining gross margin can indicate rising production costs or falling product prices.
    • SG&A Expenses: High SG&A expenses relative to revenue might indicate inefficiency, especially if growing faster than revenue.
    • Depreciation and Amortization: Non-cash expenses that can impact operating income but not cash flows, important for understanding the company’s investment in fixed assets and intangible assets.
  • Analyzing Profitability:
    • Operating Margin: Operating income as a percentage of revenue shows how efficiently a company is run. It reflects the profitability before financial structure and tax impacts.
    • Net Margin: Net income as a percentage of revenue indicates how much of each dollar earned is converted into profit.
  • Considering Non-Operating Items:
    • Interest Expense: High-interest expenses can eat into profitability and are worth noting, especially for companies with high debt levels.
    • One-time Items: Be aware of earnings impacted by non-recurring events which can skew the true economic performance of the company.
  • Bottom Line – Net Income:
    • Earnings Quality: Analyze whether net income is derived from core operations or one-time gains. Consistent income from core activities is usually a sign of a healthy company.

Key Indicators of Financial Health from an Income Statement:

  • Profitability Ratios:
    • Gross Profit Margin
    • Operating Margin
    • Net Profit Margin
  • Trend Analysis:
    • Consistency
    • Comparative Performance

Example
Increasing revenue and stable or increasing net income margins over time are indicators of financial health, suggesting effective management and a viable business model. This is especially applicable to businesses with an annual turnover greater than $1 million. Companies that have consistent growth in revenue and profitability are more likely to be able to survive economic downturns.

3. Cash Flow Statement

This statement shows how changes in the balance sheet and income statement affect cash and cash equivalents. It breaks down the analysis into operating, investing, and financing activities. Operating cash flows show the cash generated from the company’s core business operations. Capital expenditures, acquisitions, and sales of assets constitute investment cash flows. The financing cash flow shows debt, equity, and dividends as cash movements.

  • Understand the Structure:
    • Operating Activities: This section reports the cash generated from or used in the company’s primary business operations. It adjusts net income by accounting for non-cash transactions (like depreciation) and changes in working capital.
    • Investing Activities: This section details cash used in or generated from investing activities, such as the purchase or sale of physical assets (e.g., property, plant, and equipment), investments in securities, or loans made to others.
    • Financing Activities: This section includes cash inflows and outflows related to financing activities, such as issuing or repaying debt, issuing or buying back equity, and paying dividends.
  • Analyzing Cash from Operating Activities:
    • Positive Cash Flow: A positive cash flow from operating activities indicates that the company is generating sufficient cash to maintain and grow its operations, which is a good sign of financial health.
    • Trends: Consistent growth in cash flow from operations is a positive indicator. Declining cash flow, despite profitable operations, may warrant further investigation.
  • Analyzing Cash from Investing Activities:
    • Capital Expenditures: Regular, significant capital expenditures might suggest the company is investing in future growth. However, persistent high spending without corresponding increases in revenue could be a concern.
    • Sale or Purchase of Investments: Large inflows might indicate asset sell-offs which could either signal restructuring or a need for cash, depending on the company’s situation.
  • Analyzing Cash from Financing Activities:
    • Debt Transactions: New debt can finance operations and investments but increasing debt levels also raise financial risk.
    • Dividends and Share Buybacks: Regular dividends and share buybacks can be signs of a company confident in its ongoing cash flow, but these should be sustainable over the long term.
  • Free Cash Flow:
    • Calculation: Free Cash Flow (FCF) is often calculated by subtracting capital expenditures from cash from operating activities. It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.
    • Importance: FCF is a critical measure as it provides insight into the cash available to shareholders after necessary investments in the business. High or improving free cash flow is generally very positive, indicating the company has sufficient cushion to pursue opportunities, pay dividends, or reduce debt.

Key Indicators of Financial Health from a Cash Flow Statement:

  • Sustainability of Cash Flow
  • Liquidity and Solvency
  • Investment in Growth
  • Financial Flexibility

Example
The presence of positive cash flow from operating activities indicates that the company is effectively generating enough cash to maintain or expand its operations, which indicates that the company is financially healthy. Companies with positive cash flow from operating activities can also use this additional capital to invest in growth opportunities or to pay off debt. This allows them to remain competitive in the long run.

Conclusion

By analyzing a company’s balance sheet, income statement, and cash flow statement, stakeholders can gain a comprehensive picture of its financial health, which allows them to make informed decisions about investing in, managing, or extending credit to it. In order to ensure more strategic and informed financial planning and management, these financial statements should be reviewed regularly to keep track of the company’s financial performance and alert stakeholders to potential financial difficulties before they become critical.

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