How to Measure the Financial Health of a Company - Grip Invest
Who is interested in the financial health of a company? The simple answer is all the stakeholders of the company. Who all are the stakeholders of a company? Stakeholders of a company are everyone connected to and engaged with the company, from shareholders to suppliers to customers to lenders to investors to employees to society to government. Which stakeholders will be more concerned about the well-being of the company?
Some stakeholders have more interest than others in a company and hence are keener on its health than others. Simply put, the stakeholders who have more money at stake in the company are surely more eager about the state of the company. This means shareholders, lenders, investors, suppliers will be eager to know more about the position of a company than say, customers, employees.
The next logical question will be - what should the stakeholders or intending stakeholders know about the company and how will they do that?
What to look for while measuring the health of a company?
Before you invest in or join as an employee with or supply goods or services to or buy goods or services from or lend money to a company, you are supposed to perform due diligence by measuring the health, more specifically the financial health, of the company in question. However, reviewing and analysing a large volume of financial data of the company can be overwhelming.
We will briefly discuss the following measures, which would give a fair picture of the company’s current and future health. What is meant by the health of a company? It is the ability and capability of a company to scale up, make profits, generate cash flow and more importantly sustain - the capacity to navigate through and survive risks and volatile conditions. Here are some of the major measures normally applied for the purpose:
- Profitability
- Operating Efficiency
- Liquidity
- Cash Flow
- Leverage or Solvency
It should be noted that this article will only discuss what to measure to gauge the health of the company and not how in detail.
The Starting Point
You need data to measure the financial health of a company. What data do you need and where will you get it? The data required to analyze the financial and operational ratios can be collated from the financial statements of a company, like income or profit and loss statements, balance sheets, and cash flow statements and in addition board and auditor reports. These financial statements are available in the public domain for publicly listed companies. In the case of non-listed companies, these reports need to be sourced from the company directly.
Let us now understand the basic metrics to analyse a company’s financial health from various angles.
Profitability
These ratios are used to evaluate the financial viability and strength of a company by industry and market benchmarks and also the trends in the company over a certain number of years. How are various profitability ratios calculated is explained below:
Gross Margin
Gross margin is important because it is the starting point toward achieving a healthy net profit. It is calculated as Gross Profit / Revenues (Sales) where Revenues (Sales) minus Cost of Goods Sold or Sales = Gross Profit.
EBITDA Margin
EBITDA leaves an amount to take care of interests, taxes, and depreciation and amortisation. It is calculated by EBITDA / Revenues
EBIT Margin
EBI, also called Operating Profit, is calculated by deducting depreciation and amortisation from EBITDA. The ratio is derived by EBIT / Revenues
Net Profit Margin
Net Profit is EBITDA minus interest, taxes, depreciation and amortisation. Net Profit / Revenues gives you the NP margin.
Return on Assets
This ratio indicates how efficiently a company uses its assets to generate earnings.
The ratio is arrived at from EBIT x (1-Tax Rate) / Total Assets
All the above profitability ratios present a picture of a company’s profitability in terms of its revenue. The stage-wise profitability ratios tell you what cushion it leaves to take of its next stage expenses on its journey to the net profit and how far it can withstand surprises.
Operating Efficiency
Efficiency ratios are metrics that are used in analysing a company’s ability to effectively employ its resources, such as capital and assets, to generate revenue.
Inventory Turnover Ratio
The inventory turnover ratio tells you the number of times a company sells out of its finished goods inventory within a given period. The inference from this ratio will differ from industry to industry. The ratio is calculated by Cost of Goods Sold / Average Inventory1
Accounts Receivable Turnover Ratio
The accounts receivable ratio measures the efficiency of revenue collection. It measures the number of times a company collects its average accounts receivable over a given period. This is arrived by Net Credit Sales / Average Accounts Receivable
Accounts Payable Turnover Ratio
The accounts payable turnover ratio tells you the average number of times a company pays off its creditors during a period. The ratio also serves as a measurement of short-term liquidity. This is measured by Net Credit Purchases / Average Accounts Payable
Asset Turnover Ratio
This shows how efficiently is a company's assets employed in generating revenue is calculated as Net Sales / Average Total Assets
Liquidity
Liquidity measures the amount of cash and easily convertible assets that the company has to cover its debts. The following ratios are commonly used to analyse the liquidity of a company:
Current Ratio
This popular ratio measures the company’s ability to meet short-term obligations (current liabilities) from short-term assets (current assets) and is derived by Current Assets / Current Liabilities
Quick Ratio
Similar to quick ratio, this shows the company’s position to meet short-term obligation from short-term liquid obligations as = (Cash and Cash Equivalents) / Current Liabilities
EBITDA / Interest Expense
The company's capacity to meet the interest expense from earnings generated by the business is measured from EBITDA / Interest Expense
CFO / Current Debt
To gauge the capacity of the company to meet the current obligation from cash generated by the business can be understood from Cash Flow from Operation / Short Term Debts
Cash Flow
The saying - Sales is vanity, Profit is sanity, Cash is reality - shows the importance of cash flow in the measurement of the health of a company. It is vital to understand that cash balance and profit are not the same because non-cash expenses and investments are not considered in the cash flow but income statement. Consider the following common cash flow ratios used in financial health measurement:
Current Liability Coverage Ratio
The current liability coverage ratio calculates how much money is available to pay off current debt. The formula for calculating this ratio is Cash flow from operations / Average current liabilities
Cash Flow Coverage Ratio
The cash flow coverage ratio tries to gauge whether the company can meet debts with the current cash flow. The cash flow coverage ratio is derived by Cash flow from operations / Total amount of debt
Interest Coverage Ratio
How easily a company can pay service its total debt and interest can be understood from Earnings before interest and taxes / Interest
Operating Cash Flow Ratio
This ratio calculates how much cash a business makes as a result of its operations. The formula for calculating the operating cash flow ratio is cash flow from operations / Liabilities
Free Cash Flow
A very important ratio for investors. This indicates the cash generated after laying out the money required for capital expenditure and is calculated as EBIT x (1-Tax Rate) + Depreciation & Amortisation - Change in Net Working Capital - Capital Expenditure
Leverage or Solvency
Leverage ratios point to the leverage (debt) or capital structure or the solvency of the company. Following are various leverage ratios.
Debt / Equity
A famous ratio which shows the proportion of debt capital and equity capital in the total capital employed in the business and can be calculated as
where Debt = Short Term Borrowing + Long Term Borrowing + Capital Leases and Equity = Preferred Equity + Shareholder’s Equity
Debt / Capital
This ratio indicates the proportion of debt capital to total capital (debt and equity) employed in the business and can be derived by Debt / (Debt + Total Equity)
Total Liabilities / Total Assets
The proportion of total liabilities to total assets in the business and can be calculated as Total Liabilities / Total Assets
Debt / EBITDA
This ratio indicates the repaying capacity of the borrowers with the cash income generated by the business and it is calculated by Debt / EBITDA
Beyond the Financials
There are many more metrics that we can use alternatively to what we discussed above or for specific purposes. Also, which ratio is to be tested and when they are to be used, vary from case to case. For example, a supplier will be more interested in current and quick ratios than in profitability ratios.
It's also important to keep in mind that the above-discussed ratios are only one of the ways to determine the health of a company. What industry a company is in, which locations they operate, the regulations and tax regime of the respective countries, its management profile etc. play a big role in the success and sustainability of a company.
References:
1. Corporate Finance Institute <https://corporatefinanceinstitute.com/resources/accounting/cost-of-goods-sold-cogs/>
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