How to evaluate a company’s financial health before investing in its stock

Stocks aren't lottery tickets. Behind every stock is a company. If the company does well, over time the stocks do well—Peter Lynch

Investing in stocks can be highly rewarding if you select them prudently and invest only in fundamentally sound companies. Amongst all factors that you should analyse before investing in any stock, the financial health of the company stands out. If you're wondering how to evaluate the fundamentals of the company or what exactly evaluating the financial health of the company is... read on.

Evaluating the financials helps understand the performance of a company on these parameters:

Liquidity: The ability of a company to fulfil its immediate payment commitments

Solvency: The ability of a company to meet its all debt obligations

Profitability: Profitability is a measure of the earning ability of the company

Efficiency: How efficiently a company is making use of its resources

Steps to analysing a company's financial health

#Step 1: Evaluate the profit and loss statement—helps understand the Quarter-on-Quarter (Q-o-Q) and Year-on-Year (Y-o-Y) growth in revenues and profits along with profit margins.

#Step 2: Check the balance sheet—helps understand the capital structure of the company and its net worth (Excess assets after adjusting for liabilities)

#Step 3: Assess the cash flow statement— cash flow statement offers crucial information about the source of inflows/outflows viz business operations, investment activities, and financing activities.

#Step 4: Perform ratio analysis: Once you thoroughly check the profit and loss statements, balance sheet and cash flow statement, you should devote some time for ratio analysis which is one of the most crucial steps in diagnosing the financial health of a company. However, it’s noteworthy that some of the following ratios can be readily available in the financial reports of an organisation but not always, and certainly not for all companies.

But don’t worry.

Listed below are the 8 most important ratios you should consider

1. Current Ratio: Current Assets/Current Liabilities

The current ratio assesses the company’s ability to honour short-term financial obligations (falling due in a year’s time). Usually, a ratio of 1 or above is considered healthy which denotes that the company has adequate assets that can be converted in cash to pay off dues. That said, you should also look at the historical trends (year-on-year or quarter-on-quarter) to check the improvement/deterioration in the company’s liquidity position.

2. Quick Ratio: Quick Assets/Current Liabilities

(Wherein quick assets are current assets - inventory - prepaid expenses)

The quick ratio is also known as the acid-test ratio which measures the liquidity condition of a company. It’s a conservative estimate of the company’s preparedness to quickly convert its near-cash assets into cash. Here too a thumb rule says a ratio of over 1 denotes that the company might be in a comfortable position to honour its short-term debt obligations.

3. Debt to Equity: Total debt/shareholders’ equity

Debt is a two-way sword. It can help shore up revenues when managed well, however, irrational use of debt or misallocations can drag the performance of any company—irrespective of whether it is large or small.

While 0.5 to 1.0 is accepted as a healthy range for this ratio, you must analyse the debt-to-equity ratio on a case-to-case basis. For instance, in capital-intensive sectors such as manufacturing, infrastructure, and capital goods, a debt-to-equity of even 1.5 times can be tolerated if the debt servicing ability of the company is high and it is growing rapidly by making diligent use of borrowed capital.

Against that, if a company belonging to less capital-intensive sectors such as IT borrows aggressively without adding much to the bottom line, you should perform a stricter scrutiny of financials.

4. Net Debt to EBITDA: Net Debt /EBITDA

(Wherein Net debt= total debt (both short term + long term) – cash and cash equivalents

And EBITDA = Revenue - Raw Material Cost - Employee Cost - Power Cost - Freight Cost - Administration Cost - Selling/Marketing Expenses - Royalties (if any) - Other operating expenses)

The Net-debt-to-EBITDA ratio helps you understand how aggressively the company has borrowed money and whether it’s generating adequate earnings to service and repay the total debt on its book. Any ratio above 2.5-3 should be a red flag.

5. Return on Equity: Net profit/shareholders’ equity

Return on equity (RoE) is one of the most popular ratios widely used to perform comparative analysis of companies. It is expressed in percentage terms—the higher the better—since RoE denotes how efficiently the company is utilising shareholders’ capital to generate profits. Usually, mature and efficiently run companies with a small equity base and low requirement of growth capital generate high RoE and vice-versa.

It is noteworthy that corporate actions such as right issuances result in equity dilution which in turn drags RoE. On the other hand, share buybacks show a positive impact on RoE.

6. Return on invested capital: Net income/capital invested

If RoE measures the returns accruing to equity shareholders, RoIC considers the return a company generates by employing capital from all sources (equity + debt). RoIC is more relevant for capital-intensive business as it reflects the company’s efficiency (inefficiency) in deploying capital for generating profits. This ratio too is expressed in percentage terms—the higher the better.

Unlike RoE which doesn’t reflect the company’s indebtedness, RoIC gives you a clearer and more holistic view.

7. Asset Turnover: Total revenue/ average assets

Having assets on books is one and making their efficient use is another. Asset turnover helps you understand the company’s ability to utilise its assets to maximise its revenue.  Asset turnover of less than 1 would indicate either the company has purposefully built higher inventories for the future or it’s using its assets inefficiently. Thus, you have to study the asset turnover ratio of any company individually.

8. Inventory Turnover: Cost of goods sold (COGS) / Total average inventory

(Wherein COGS= Inventory at the beginning of a period + fresh purchases- inventory at the end of a period

And Average inventory: (Previous inventory + current inventory)/ total number of periods)

If you are measuring the efficiency of a manufacturing company then the inventory turnover ratio may come in handy as it indirectly indicates the performance of the sales function. The inventory pileup may either indicate that the sales have been poor or the company has been building additional inventory to meet future rises in demand. Higher inventory levels block the working capital thereby putting strain on short-term finances of the company.

In Summary

Evaluation of profit and loss accounts, balance sheets, cash flow statements, and various ratios collectively offer vital information about the company’s financial health.