When evaluating companies for investments, it's important to look at them in the context of their own sector. Each sector has different attributes that vary from other sectors. For example, capital intensive sectors, like airline and manufacturing companies, have high levels of debt, while Internet companies typically have low levels of debt. Comparing them would not be an apples-to-apples comparison. As such, different ratios are better suited to analyzing certain sectors than others.

Some key financial ratios investors and market analysts use to evaluate companies in the healthcare sector include the cash flow coverage ratio, the debt-to-capitalization ratio, and operating profit margin.

Key Takeaways

  • The healthcare sector encompasses companies in a variety of areas, including hospitals, medical equipment manufacturers, and pharmaceuticals.
  • Investors are bullish on the healthcare sector as they believe it is stable and a good defensive play against a downturn in the economy.
  • The healthcare sector has consistently been one of the best performing sectors in terms of growth.
  • Hospitals and medical practices often have to wait for long periods of time for reimbursements from insurance companies, hence utilizing the cash flow ratio as an assessment of a company's ability to cover its debt obligations is a good metric.
  • Many healthcare companies have high capital expenditures, so analyzing the debt-to-capitalization ratio helps determine if they have enough capital to meet their long-term debt obligations.
  • Operating margin allows investors to see the amount of profit a company makes from its core operations, before the deduction of interest and taxes.

An Overview of the Healthcare Sector

The healthcare sector is one of the largest market sectors, encompassing a variety of industries such as hospitals, medical equipment manufacturers, and the pharmaceutical industry. The sector is popular among investors for two reasons.

First, it is viewed by many investors as containing stable industries that offer a good defensive play to help weather general economic or market turndowns. Regardless of the state of the economy, individuals continually need healthcare.

Hospital and pharmaceutical revenues may suffer somewhat during difficult economic times, but the overall consumer demand for healthcare services is considered less subject to significant drop-off due to economic conditions than is the case for sectors such as the retail sector or automotive sector. While healthcare stocks may decline in conjunction with an overall bear market, they are generally considered less vulnerable than the stocks of companies in many other sectors.

The second major reason the stocks of healthcare companies are attractive to investors is the fact that the sector has consistently been one of the best-performing sectors in terms of growth. Two contributing factors to the sustained growth of companies in the sector are an aging baby-boomer population in need of ongoing health services and continued development in the fields of medical technology and pharmaceutical disease treatments.

Evaluating Healthcare Stocks

Because the healthcare sector is so broad, investors need to compare similar companies within the same industry in the sector when making equity evaluations. Some key ratios can be effectively used in a basic analysis of virtually all healthcare stocks.

Cash Flow Coverage Ratio

The cash flow coverage ratio is a good general evaluation metric, but it can also be particularly important for businesses such as hospitals and medical practices. Because such companies must often wait substantial periods of time to obtain financial reimbursement from insurance companies or government agencies, having sufficient cash flow and good cash flow management is essential to their financial survival.

Certain pharmaceutical companies can be a risky investment as they spend significant capital on research and development (R&D) of a drug, and if that drug does not pass regulatory approval, the company can suffer significant losses. It is more conservative to invest in pharma companies that already have a number of viable drugs on the market.

This ratio is calculated by dividing operating cash flow, a figure that can be obtained from a company's cash flow statement, by total debt obligations. It reveals a company's ability to meet its financing obligations. It is also a ratio considered particularly important by potential lendersĀ and therefore impacts a company's ability to obtain additional financing, if necessary. A ratio of 1 is generally considered acceptable, and a ratio higher than 1, more favorable.

Debt-to-Capitalization Ratio

The long-term debt-to-capitalization ratio is an important leverage ratio for evaluating companies that have significant capital expenditures, and therefore substantial long-term debt, such as many healthcare companies. This ratio, calculated as long-term debt divided by total available capital, is a variation on the popular debt-to-equity (D/E) ratio, and essentially indicates how highly leveraged a company is in relation to its total financial assets. A ratio higher than 1 can indicate a precarious financial position for the company, in which its long-term debts are greater than its total available capital. Analysts prefer to see ratios of less than 1 since this indicates a lower overall financial risk level for a company.

Operating Margin

Operating margin is one of the main profitability ratios commonly considered by analysts and investors in equity evaluation. A company's operating profit margin is the amount of profit it makes from the sales of its products or services after deducting all production and operating expenses, but prior to consideration of the cost of interest and taxes.

Operating margin is key to determining a company's potential earnings, and therefore in evaluating its growth potential. It is also considered to be the best profitability ratio to assess how well-managed a company is since the management of basic overhead costs and other operating expenses is critical to the bottom line profitability of any company. Operating margins vary widely between industries and should be compared between similar companies.

The Bottom Line

Evaluating a company can be a difficult task as there is a lot of information to dig through, and it may be difficult to determine what is particularly relevant to the company at hand. Utilizing the common financial ratios used to analyze companies in a specific industry can be a great way to gain an understanding of the fundamentals of that industry and the companies that operate within it.