When valuing a stock, investors always look for that key golden metric that can be obtained by looking at a company’s financial statements. But finding a company that ticks all the boxes just isn’t that easy.
There are a number of financial ratios that can be looked at to assess the overall financial health of a business and to judge the likelihood of the business continuing to be a viable business. Stand-alone figures such as total debt or net profit are less significant than financial ratios that link and compare different figures on a company’s balance sheet or income statement. The general trend of financial ratios, as they improve over time, is also an important consideration.
To accurately assess the financial health and long-term viability of a business, several financial metrics need to be considered in tandem. The four main areas of financial health to examine are liquidity, solvency, profitability and operational efficiency. However, of the four, perhaps the best measure of a company’s health is its level of profitability.
Key points to remember
- There is no ideal way to determine the financial health of a business, let alone sustainability, despite the best efforts of investors.
- However, there are four critical areas of financial well-being that can be looked at closely for signs of strength or vulnerability.
- Liquidity, solvency, profitability and operational efficiency are important areas to consider, and all should be considered together.
Liquidity is a key factor in assessing the basic financial health of a business. Liquidity is the amount of cash and easily convertible assets into cash that a business has to manage its short-term obligations. Before a business can thrive in the long term, it must first be able to survive in the short term.
The two most common metrics used to measure liquidity are the current ratio and the quick ratio.
Of these two, the quick report, also known as the acid test, is the conservative measure. This is because it excludes inventories from assets and also excludes the current portion of long-term debt from liabilities. Thus, it provides a more realistic or practical indication of a company’s ability to manage its short-term obligations with available cash and assets. A quick ratio below 1.0 is often a warning sign, as it indicates that current liabilities exceed current assets.
A company’s net profit margin is the best indicator of its financial health and long-term viability.
The concept of solvency is linked to liquidity, that is to say the ability of a company to honor its debts on a continuous basis, and not just in the short term. Solvency ratios calculate a company’s long-term debt relative to its assets or equity.
The debt-to-equity (D / E) ratio is generally a strong indicator of a company’s long-term viability, as it provides a measure of debt to equity and therefore is also a measure of interest. and investor confidence in a company. A lower D / E ratio means that more of a company’s operations are financed by shareholders rather than creditors. This is a plus for a company since shareholders do not charge interest on the financing they provide.
D / E ratios vary widely from industry to industry. However, regardless of the specific nature of a business, a downward trend over time in the D / E ratio is a good indicator that a business is on an increasingly solid financial footing.
The operational efficiency of a business is the key to its financial success. The operating margin is one of the best indicators of efficiency. This measure takes into account a company’s basic operating profit margin after deducting the variable costs of producing and marketing the company’s products or services. Above all, it indicates the extent to which the management of the company is able to control costs.
Good management is essential to the long-term viability of a business. Good management can overcome a range of temporary problems, while bad management can lead to the collapse of even the most promising business.
Financial ratios can be used to assess the overall health of a business; stand-alone figures are less useful than those that compare and contrast specific figures in a company’s financial statements.
While liquidity, basic solvency, and operational efficiency are all important factors to consider in valuing a business, the end result remains a business’s bottom line: its bottom line. Companies can survive for years without being profitable, relying on the goodwill of creditors and investors. But to survive in the long term, a business must ultimately achieve and maintain profitability.
A good measure to assess profitability is net margin, the ratio of net profits to total revenues. It is essential to take the net margin ratio into account, as a simple dollar profit figure is insufficient to assess the financial health of the business. A business may have a net profit of several 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 market competition could. plunge the company into the red.
A larger net margin, especially compared to its industry peers, means a greater margin of financial security and also indicates that a business is in a better financial position to engage capital in growth and expansion.
The bottom line
No single metric can identify the overall financial and operational health of a business.
Liquidity will tell you a company’s ability to weather short-term difficulties, and creditworthiness will tell you how easily it can cover long-term debt and obligations. Efficiency and profitability, meanwhile, say a lot about its ability to convert inputs into cash flow and bottom line.
All these factors must be taken into account to have a complete and holistic view of the stability of a business.