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.

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, and the pharmaceutical industry. The sector is popular among investors for two very different 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.

For the same reason, 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 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-boom 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, it is important for investors to compare similar companies within the same industry in the sector when making equity evaluations. However, there are some key ratios that 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.

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 lenders 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 in 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.