What Is a Financially Healthy Company, Anyway?
April 3, 2023
What Is a Financially Healthy Company, Anyway?
We don’t need to be architects to know what went wrong for two out of the Three Little Pigs. They built houses of straw or sticks in a world with big bad wolves possessing truly astonishing lung capacities. Hmm. Granted, who would have anticipated wolves with big lungs?
But I can anticipate that even the most promising companies will face challenges. Some will be external to the company, like a slumping economy or a new competitor. Others will stem from poor strategy or errors of execution. Firms need resources they can call on when there’s a crisis.
As investors, we want to monitor first if a company’s financial position is deteriorating and, second, if it has enough resources to survive. The smaller the company, the closer attention you should pay to financial health. Most large-cap companies have ample resources to cover a few disappointing quarters. Startups and fallen angels (former blue-chip stocks suffering hard times) often don’t. But frequently they offer the most investment potential at the cost of requiring more investor attention.
Your first step should be to check the company’s credit ratings, if they’re available. There are three major credit rating agencies, Moody’s, Standard & Poor’s and Fitch Ratings as a distant third. Each has a different rating system, but if you see three letter A’s together in the same rating, whether upper or lowercase, that’s the highest rating. If you see any C’s or D’s, it’s time to grab a pencil.
Make your life easier by only doing as much analysis as necessary. First, if the company is steadily paying a dividend and there’s no buzz floating around about cutting it, chances are pretty high the company isn’t distressed. The same is true — but not necessarily — if the company’s reported earnings have been consistently growing. When the stock under study isn’t as bright-eyed or rosy-cheeked as what we might prefer, that’s the time to go into more detail.
First, assess where the damage comes from. The most threatening sign of long-term distress is declining revenue, followed by declining gross profit margins. Businesses need to be able to generate revenue and at least generate an acceptable profit on selling each unit. Compare that stock’s gross profit margins with its competitors. That will tell you if the industry is the problem or the company’s offerings are the culprit. If the profit margins are significantly lower, then check to see whether the company is selling enough product at that lower profit margin in case it’s pursuing a high volume strategy to build market share. If those don’t yield easy answers, it’s time to dive deeper into the financial statements.
Reported earnings tell investors about the changes to shareholder wealth, but not automatically whether the company will be able to pay the bills three years down the road. Companies can tinker with reserve accounts to make profits seem healthier than they are. When earnings might not be telling the whole story, the name of the game becomes cash flow, more specifically, free cash flow.
Free cash flow to the firm (FCFF) is the amount of cash the company generates from operations after capital expenditures (capex). Analysts assume the capex necessary to keep factories running, computers working and the headquarters building from collapsing (especially if it was built with straw). It removes the effects of leverage and maintains the focus on the core business, since companies can only sell off assets to pay bills for a limited time until there’s nothing left.
On a less ominous note, free cash flow may indicate the company is far stronger than what the earnings indicate. Amazon focused on cash flow instead of earnings, and we all know how that story turned out.
There are a number of ways to calculate FCFF. One route uses the income statement and the other uses the cash flow statement. Rather than describing in detail the many different ways to do it in this column, it might be easier to search for a method that you’re most comfortable with online. If you’re working with the income statement, calculate free cash flow from:
“Reversing changes to working capital” means adding to EBIT any reductions in inventory, accounts receivable and other short-term assets, because that means cash was generated. We do the opposite if inventory increased or accounts payables increased, because that’s when cash was used.
If the business isn’t generating enough cash, the next question needs to be about its ability to stay solvent. That’s when we start looking at the balance sheet and notes to the financial statements. Keep in mind firms in different industries will have very different liquidity needs. Supermarkets have very high inventory turnover and can be very profitable in spite of having higher short-term payables than assets.
There are a number of ratios that measure a concern’s ability to pay its bills. We’ll look at them in the increasing order of liquidity; the first measure, the current ratio, assumes there isn’t any problem liquidating non-cash assets. The last one focuses entirely on cold, hard cash.
The current ratio is simply current assets divided by current liabilities. If the number is below one, that indicates the firm has more liabilities than immediate resources to pay them without finding external sources of cash or firm revenues.
If you’re worried the inventory won’t turn over quickly, first, yikes. The next ratio to check will be the quick ratio. That’s the sum of cash, marketable securities and accounts receivable divided by current liabilities. If you’re still concerned about the company’s ability to collect accounts receivable and sell its marketable securities, then there’s one more ratio, the acid test ratio. That’s simply cash and cash equivalents divided by current liabilities.
It’s better when companies don’t need to raise money from outside sources in lean times, but they often have resources to call on beyond the balance sheet (but they may appear in the footnotes). The more distressed the business is, the more costly it might be to borrow money or issue stock.
Before the firm resorts to issuing costly unsecured debt or equity, it may have revolving lines of credit, or it may pledge its assets as collateral to borrow money.
Ford (ticker: F) pledged virtually all of its assets, including the Blue Oval itself as collateral for loans during the Great Recession rather than accept the conditions of a government bailout. Car buyers noticed the bravado and the gambit paid off, both for the CEO who didn’t need to accept a $1 a year paycheck and for the company that wasn’t answerable to the government as a
borrower.
Obviously, companies want to be liquid enough to avoid bankruptcy and to get favorable borrowing terms. But they can also be too liquid.
The ideal liquidity for any stock is the level that optimizes shareholder wealth. That’s determined by the industry, the company’s strategy and current business conditions. Companies that have too much in cash reserves should either distribute it to shareholders through dividends or stock buybacks. If they don’t, they are wasting an asset and the share price will be unnecessarily depressed. That might invite activist investors to seek control of the company.
In tough times, you want to be the little pig with the house of bricks. But during normal business conditions when there’s no wolf at the door, we might take Goldilocks’ perspective, who wanted her porridge “just right.” If there’s too little liquidity, the company might be too stressed to take full advantage of the best opportunities.
But hoarding excessive cash is also a sign of poor management that eventually shows up in return on assets and other measures that influence stock price.
