Judging a Company's Financial Health
Your task as your own fundamental analyst is to determine the financial health of a company—whether you are thinking of buying, holding, or selling a stock. The financial statements of the company serve as your basic documents for making this judgment. However, financial health might have several different definitions. To be accurate in your judgment, you need to make comparisons, and you also need to ensure that your comparisons are applied fairly in each case.
So how do you define a financially healthy company? Some standard methods for applying this definition include the following:
Increases in sales volume. People usually assume that a growing company is a healthy company. While this is true, you also need to ensure that a company is growing in the right way. One of the more popular and standardized tests is the dollar amount of sales from one year to another. Most people, when thinking of growth in corporate terms, first think of total sales as the best measure. However, this is a troubling indicator when looked at in isolation. Growth by itself is not necessarily a positive sign; in fact, growth can do a lot of damage to a company's financial health if not properly controlled. What good are increased sales if the amount and yield of net sales are falling? You also need to know the cause of sales volume in order to understand its significance. If volume growth results solely from new acquisitions, it is not growth at all, but merely a reconfiguration of the base. Volume growth due to more unit sales or higher prices has an entirely different interpretation.
KEY POINT
The importance of ever-growing sales volume receives too much emphasis. If overly rapid expansion results in a cash flow crisis, the sales increase is not good for the company's long-term health.
Growth in sales volume and net margin. A more accurate measure of health is a combination of sales volume and net margin. In other words, if sales are increasing each year while the net margin (percentage of net sales to total sales) remains at the same level or within a reasonable range, this is healthy growth. If sales volume and net margin are coordinated in this manner—especially if cash flow continues to be carefully controlled by management—then a good growth pattern emerges and the company can be considered fiscally healthy.
Growth in net profit dollar amount. Another popular but misleading way to measure growth is by looking only at the dollar amount of net profits. It is far more important to be aware of net margin than the dollar amount of sales. For example, look at the following pattern of sales and profits, along with the net margin:
Year Sales d d d d d d d d Profits d d Net Margin
1 $14,633,200 $1,536,500 10.5%
2 17,561,000 1,740,200 9.9
3 21,080,600 1,877,400 8.9
4 26,993,400 2,174,300 8.1
5 31,003,100 2,241,900 7.2
Note that while profits are rising each year along with growth in sales volume, the net margin is falling. Such a trend is troubling. It shows that management is not able to properly maintain its relative yield with growth. So a growth in net profits alone can be deceiving.
Competitive position. If the company you are considering has competitors within its industry, a good way to measure its health is by comparing all of the fundamentals to those of its competitors—not once, but as a series of relative trends. You will be able to spot emerging new leaders and the gradual decline of older ones by watching how the fundamentals change—sales volume, net margin, asset strength, and other tests. In applying fundamental tests to a company, comparisons to other companies in the same industry are highly useful, because all competitors are subject to the same economic influences in the same way. For example, a company whose operations are sensitive to rising interest rates shares that characteristic with all other companies in its industry.
Assets and shareholders' equity. Some fiscal health can be measured in terms of book value. As a company grows and accumulates profit, it should also be able to reduce its relative share of debt, increase the value of its assets, and gain financial strength overall. If a company experiences growth but loses shareholders' equity, then it is probably depending too heavily on debt capital, or failing to manage cash flow adequately. Higher profits are not worth the effort if they result in endangering the future financial strength of the organization.
Capitalization mix. Corporations capitalize their growth through a combination of methods. Shareholders, of course, buy shares of stock and provide the corporation with equity capital. Corporations also may borrow money through notes and loans or by issuing bonds. These are forms of debt capital and must be repaid with interest, which reduces net income. Equity capital, in comparison, may or may not be compensated through dividend payments. The mix of capital is an important test, not just of growth, but how growth is achieved. If a corporation becomes excessively dependent on debt capital, it may erode current and future earnings through ever-increasing interest expense.
Dividend rate. The fundamentalist is always aware of yield and, to some degree, technicians also appreciate the significance of high-yielding stocks. A corporation's health often is judged by the consistency of dividend payments, the steady or increasing rate of payment, and the significance of any reductions in rate or even skipped dividends.
Stock price. Ultimately, the majority of individual investors, including all technicians, judge a company's health by how well its stock price moves upward or, equally important, how well it holds its value when the rest of the market is falling. Stock price reflects demand and a perception of potential growth for the company, so a stock's price strength does reflect what the market believes about the company. You will discover that companies with strong fundamentals (sales volume, net margin, dividend payment rates, asset strength, and price-earnings ratio) also tend to have more stability in stock price.
