If you’re thinking about investing in an individual company, you should make sure you take the time to analyse its financial health before investing. Investing in a business that is a picture of financial health means it’s less likely to require outside capital to stay afloat and more likely to be able to ride out any financial storms. As Warren Buffett says, “it’s only when the tide goes out that you learn who has been swimming naked.”
Thankfully, there are certain metrics that you can adopt to determine the financial health of a company. These numbers paint quite a detailed picture of the effectiveness of a company’s management team, competitive advantage, liquidity, and overall financial health.
To point you in the right direction, here’s a list of 5 different metrics worth looking at.
A Word On The Lingo
Before we get stuck in, let me warn you that some of the terms used in this article aren’t all beginner-friendly. To keep you in the loop, we’ve created a free financial lingo glossary, which can be downloaded here.
1. Healthy Free Cash Flow (FCF)
Free cash flow is the cash a business has left over after all capital expenditures. With free cash flow, the name says it all. FCF is the leftover cash a business keeps after accounting for cash used to support operations and maintain assets.
What You Need To Know About FCF.
FCF tells us if the profits of a company are aligned with their ability to retain cash. Growth in FCF is a great indication of whether profits are growing with cash or they’re paper profits only. Cash growth complemented with profit growth is generally a great combination.
Positive FCF is great because it gives the management team options. They can use their surplus cash to pay a dividend, re-invest it to grow the business further, re-purchase their own stock, or simply keep it in cash. While options are great, it’s important to understand if the management team is making the most of their FCF, but I’ll leave that for another post.
It’s worth noting that FCF can fluctuate from year to year depending on capital expenditures. I often find that Cash Flow from Operations is a great alternative, and can tell a more consistent story of a company’s ability to produce cash through the years.
Where to find FCF
Free cash flow isn’t a widely accepted accounting metric, so it may not be reported by a company. Fortunately for us, FCF can be calculated pretty easily through this formula:
FCF = Operating Cash Flow – Capital Expenditures
2. Growing Earnings Per Share (EPS)
Earnings per share or EPS is a monetary value employed to determine the profit a company generated per each outstanding share. EPS is calculated by dividing a company’s net income by its total amount of common shares outstanding.
EPS = Net Income/Shares Outstanding
Should a company make a net loss for a given quarter or year, then the EPS will be negative for the time period.
How EPS can help identify a company’s financial health.
A company with positive and growing earnings per share is a great sign of a profitable and growing business. Exactly the type of business I, and many other great investors want to be invested in.
Most of the time, you’ll find that a company’s earnings are closely correlated with its stock price. If earnings rise, so does the stock price and if earnings fall, well, I’m sure you can figure out what happens next!
Take Alphabet, the parent company of Google (NASDAQ:GOOGL) as an example. Alphabet has grown its EPS at a healthy rate roughly 15% per year over the past 10 years (2009-2019). In the corresponding period, Alphabet’s stock price has risen by roughly 15% per year. Coincidence? I think not.
Where to find EPS
Luckily for us, most websites providing company data like Macro Trends or Yahoo Finance will provide annual and quarterly EPS numbers. With that said, it’s always worth checking a company’s income statement to determine whether they’ve calculated EPS themselves.
You can find the income statement in a company’s annual and quarterly reports. Simply Google ‘company X annual report’ and you’ll be taken to that company’s investor relations window, wherein the company reports lie.
3. Healthy Debt To Equity Ratio
The Debt to Equity Ratio is calculated by dividing a company’s total liabilities by its shareholder equity. Both of these numbers can be found on the balance sheet.
This ratio is useful to determine the extent of leverage a company is using. In other words, it tells us whether a company is financing its operations through debt or if they’re utilising their own funds.
What You Need To Know About The Debt To Equity Ratio.
A solid debt to equity ratio really shows its worth during a business downturn where profits have tried up but debt obligations still need to be met. Referring back to the quote by Warren Buffett mentioned earlier in this article, this is where you really find out who’s been swimming naked.
A great D/T ratio varies by industry, but ideally, it should not be above 2.
Where to find the D/E Ratio
Just like FCF, the debt to equity ratio may not be reported by a company. With that said, the debt to equity ratio can be calculated by using this formula:
D/E = Total Liabilites / Total Equity
4. Strong Current Ratio
The current ratio is a measure of short-term liquidity. It’s employed by investors to determine if a company has sufficient liquid assets to meet its liability obligations over 12 months.
What You Need To Know About The Current Ratio.
A good current ratio is anything between 1.2-2 and anything above 2 is great! If a business has a current ratio above 2, its current assets double its current liabilities, placing the business in a strong position to cover its short term debts.
A current ratio below 1 isn’t ideal because it generally implies that a business does not have enough short term liquid assets to cover its short term liabilities.
Where to find the current ratio
Most of the time, websites like Yahoo Finance will calculate the current ratio for you. Alternatively, you can calculate it by dividing the company’s current assets by its current liabilities.
Current Ratio = Current Assets/Current Liabilites
Both of these numbers are available on the balance sheet.
5. Shareholder Equity
Shareholders’ equity, also known as book value is the difference between a company’s total assets and total liabilities. Shareholder equity tells us what would be left over for shareholders if all assets were liquidated and all liabilities are paid to creditors.
Why shareholder equity is an important indicator of financial health.
Shareholders’ equity can either be positive or negative. In the case where a company’s total assets are greater than its liabilities, shareholder equity would be positive. In the opposite scenario, shareholder equity would be negative.
The shareholder equity number by itself isn’t overly important. For example, a business with a lot of real estate like Scentre Group (ASX:SCG) can accumulate a large amount of equity relative to their value. However, businesses that rely on their intellectual property might have a smaller amount of equity in comparison to their value. What’s is important is shareholder equity growth.
Shareholder Equity growth is a fundamental metric to consider because it tells us whether or not a business can effectively accumulate a surplus. Without a surplus, a company is more restricted in terms of the funds it needs to develop products or increase market share.
Where to find shareholder equity
Most websites providing company data like Macro Trends or Yahoo Finance will provide annual and quarterly shareholder equity numbers.
Alternatively, shareholder equity figures are easily found at the bottom of a company’s balance sheet.
My final thoughts on financial health metrics
While each of these numbers is super important to know and understand when considering a company’s financial health, there is a lot more to consider about a business before investing. It can take weeks and months of careful scrutiny for the world’s best investors to invest in a company, so please don’t assume you’re ready to invest with these 5 numbers only.
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About The Author – Jesse
Hi, I’m Jesse, but you can call me Jes for short. My passion is simple, I’m on a mission to make the world of investing easily understood by removing the ‘too hard basket’ stigma that surrounds it.
Disclaimer: This website (the “The Money Pal”) is published and provided for informational and entertainment purposes only. The information in the Blog constitutes the Content Creator’s own opinions and it should not be regarded as financial advice.