Sunday, August 28, 2011

How strong is a company in terms of its financial health?

Evaluating a company’s financial health is no rocket science. Many investors dare to read companies balance sheets and income statements assuming that it will be too difficult to comprehend. But let me tell you, judging companies financial health from its balance sheet and income statements is easy. This article is aimed at providing know how to its readers helping them to gauze the companies’ financial health.

What is that one financial parameter that decides a company’s financial health? It is called the ‘Net Worth’ of a company. In order to understand what is net worth let me give you one easy example. If I will ask you, as an individual what is your net worth? The answer should be:

What I own (asset) – What I owe (Liability) = My Net Worth.

Now what does it means?
What Assets I own?
(1)   Cash In Savings Account       = $ 5,000
(2)   Mutual Funds                       = $ 10,000
(3)   Equity/ Shares                     = $ 2,000
(4)   Bonds                                 = $ 5,000
(5)   House                                 = $ 100,000
Total                                          = $ 122,000

What Liabilities I owe?
(1)   Outstanding Credit Card Bill     = $ 600
(2)   Balance Mortgage Payment    = $ 50,000
(3)   Unpaid Bills                           = $ 500
Total                                          = $ 51,000

What will be My Net Worth
What I own (asset) – What I owe (Liability) = My Net Worth.
$ 122,000 – $ 51,000 = $ 71,000

Similarly the net worth of a company can be calculating by noting its total assets and total debts to calculate its net worth. A companies with an above average growth rate of its Net Worth can be called as a Financially strong company.

The hearth of financial well being of company is exemplified in its balance sheets.

Let us note what are the most important things to be noted by investors in a company’s balance sheets

(1) Current Assets and Current Liabilities.
Knowing the levels of current assets and current liabilities of a company is a good way of judging the short term capability of company to pay its dues. All receivable on or before 12 months are called as current assets and all due payment to made within next 12 months are categorized as current liabilities. But this is maybe we all already know, but what extra getmoneyrich can give you here?

Important question here to asked is whether a company is managing its current assets and liabilities well? A company which is able to manage this well means they have excellent cash flow management. Why cash flow? All companies has dues that they need to pay in terms of vendor payment, taxes, employees salary, other overheads etc.

In order to manage these short term cash outflows, the company must also develop streams of cash-inflows. Suppose in particular year a company has made payments worth $1 million and they have collects payments worth $1.2 million, it means that this company has been able to pay all its outstanding dues. In this example current liability is $1Mn and current asset is $1.2Mn.

(1a) Managing Current Asset by managing Inventory
The main constituent of current asset is the its inventory. In last year’s Balance sheet of a company, suppose inventory level (one of the biggest current liability for a company) is reported as say $5Mn with an with corresponding sales figures as $50Mn. Compare these figures with the present years balance sheet figures, suppose the values are $5.5Mn (inventory) & $60Mn (Sales). Let us see how it talks about the current liability management:

Last YearPresent Year
$5Mn$50 Mn$5.5 Mn$60 Mn
Sales/ Inventory1010.9

Analyzing last year’s inventory/ sales figures
For every $1 million of inventory accumulated by the company they are affecting $10 Million of sale.

Analyzing present year’s inventory/ sales figures
For every $1 million of inventory accumulated by the company they are affecting $10.9 Million of sale. It means that the company is able to sell its finished goods (inventory) faster. Which automatically translates into more cash-in flow. A company which is able to continuously increase its ‘inventory turnover ratio’ (Sales/Inventory) year after year hints at companies focus on bettering cash flow management. As a rule of thumb, if a company can manage its immediate cash flows (payments Vs. collections) it can be classified as financially healthy. All good companies will strive to maximize the level of sales for a given level of inventory.

(1b) What level of current asset and current liability is good.
Current ratio is the ratio of current assets and current liability. This ratio will allow you to understand the ability/ strength of the company to pay its short term dues. Current ratio should neither be too high nor too low. As a rule of thumb, current ratio shall be near to 2, too low or too high above this level indicates problem within the company,

In order to understand the behavior of current ratio of a company, it is better to see the past. See how the company has managed its current ratio in last five years.

(2) Net worth of a company is another important indicator of its improving financial health.
Net worth of a company is equal to shareholders equity plus retained earnings.

Net Worth = Shareholders Equity + Retained Earnings.

Shareholder’s equity is the money contributed by the shareholder’s in IPO. Suppose a company X issues shares 10 million shares in the market at average price of $10 per share. The fund accumulated by the company by issuing these 10 million shares is 10 million nos. x $10 = $100 million. By using this fund (shareholders equity), company tries to increase its turnover and profitability by undertaking modernization or expansion plans. Unless the company is issuing new IPO’s, the shareholders capital remains constant over a period of time. If our example company X, suppose in next five years the company issues no new IPO’s it means the pattern of shareholders capital will look like this

Year 0Year 1Year 2Year 3Year 4
Shareholder’s Capital$100 million$100 million$100 million$100 million$100 million

Out of the net profit that this company makes, the board of directors decide to disburse a proportion of this net profit among shareholders as dividends. Increased net profits means increased dividends. Balance net profits (after dividend disbursements) are called as retained earnings. This money is reflected in the balance sheet of the company. Suppose our company X makes $10 million net profit in year 1. Board of director decides that 50% of the net profits will distributed as dividends, 30% will be used for expansion and modernization projects and balance 20% will be the retained earnings. If this company increase its net profits by 12% each year then the pattern of retained earnings will look like this:

Year 0Year 1Year 2Year 3Year 4
Net Profit$ 10 million$ 11.2 million$12.5 million$14 million$15.7 million
Cumulative Retained Earnings @ 20%$0 million$2.2 million$2.2+2.5 = $4.7 million$4.7+2.8 = $7.5 million$7.5+3.2 = $10.7 million

So this increasing level of retained earnings will contribute to Net worth of the company. Let us see how:
Year 0Year 1Year 2Year 3Year 4
Shareholder’s Capital$100 million$100 million$100 million$100 million$100 million
Cumulative Retained Earnings @ 20%$0 million$2.2 million$4.7 million$7.5 million$10.7 million
Net Worth$ 100 million$102.2 million$104.7 million$107.5 million$110.7 million

Ideally speaking if you are interested to buy a company in totality, the minimum price you should pay to own it is its net worth. But generally a company is prices always above its net worth. The ability of company to generate future earnings, the brand name etc increase the value of the company. Like if you will compare the market price/share of a company with its net worth/ share, market price will always be higher.

As an intelligent investor, you must always take you net worth/ share levels as your base levels and compare the current market price w.r.t to this. Suppose our company in year 4 has following valuations:

Company XIn Year 4
Market Price/ Share$ 150
Net worth/ share$ 11.07
Market Price/ New worth13.55

You can see how overvalued the stock market values a company as compared to its net worth. As a rule of thumb, if a share is trading nearly at 15 times its net worth then you can say that the share is a good contender for a valuable buy.

Best will be compare the market price/ book value with similar companies of same sector. This will give you an idea that how this share is placed as compared to its competitors.

Knowing companies financial health before buying its share is very important. Important parameter to be considered are sales/inventory figures, current ratios and market price/ net worth levels.
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