When evaluating a stock, investors are always searching for that one golden key measurement that can be obtained by looking at a company's financial statements, but finding a company that ticks off every box is simply not that easy.
To accurately evaluate the financial health and long-term sustainability of a company, a number of financial metrics must be considered. Four main areas of financial health that should be examined are liquidity, solvency, profitability and operating efficiency. However, of the four, likely the best measurement of a company's health is the level of its profitability.
There are a number of financial ratios that can be reviewed to gauge a company's overall financial health and to make a determination of the likelihood of the company continuing as a viable business. Standalone numbers such as total debt or net profit are less meaningful than financial ratios that connect and compare the various numbers on a company's balance sheet or income statement. The general trend of financial ratios, whether they are improving over time, is also an important consideration.
- There's no one perfect way to determine a company's financial health, let alone sustainability, despite investors' best efforts.
- However, there are four critical areas of financial well-being that can be scrutinized closely for signs of strength or vulnerability.
- The four areas to consider are liquidity, solvency, profitability and operating efficiency.
- All four are important, but the most significant measure of a company's financial health is its profitability.
Liquidity is a key factor in assessing a company's basic financial health. Liquidity is the amount of cash and easily-convertible-to-cash assets a company owns to manage its short-term debt obligations. Before a company can prosper in the long term, it must first be able to survive in the short term.
The two most common metrics used to measure liquidity are the current ratio and the quick ratio. Of these two, the quick ratio, also sometimes referred to as the acid test, is the more precise measure, since, in dividing current assets by current liabilities, it excludes inventory from assets and excludes the current part of long-term debt from liabilities. Thus, it provides a more realistically practical indication of a company's ability to manage short-term obligations with cash and assets on hand. A quick ratio lower than 1.0 is a danger signal, as it indicates current liabilities exceed current assets.
A company's bottom line profit margin is the best single indicator of its financial health and long-term viability.
Closely related to liquidity is the concept of solvency, a company's ability to meet its debt obligations on an ongoing basis, not just over the short term. Solvency ratios calculate a company's long-term debt in relation to its assets or equity.
The debt-to-equity (D/E) ratio is generally a solid indicator of a company's long-term sustainability, because it provides a measurement of debt against stockholders' equity, and is therefore also a measure of investor interest and confidence in a company. A lower D/E ratio means more of a company's operations are being financed by shareholders rather than by creditors. This is a plus for a company since shareholders do not charge interest on the financing they provide.
D/E ratios vary widely between industries, but regardless of the specific nature of a business, a downward trend over time in the D/E ratio is a good indicator a company is on increasingly solid financial ground.
A company's operating efficiency is key to its financial success. Its operating margin is the best indicator of its operating efficiency. This metric indicates not only a company's basic operational profit margin after deducting the variable costs of producing and marketing the company's products or services; it thereby provides an indication of how well the company's management controls costs.
Good management is essential to a company's long-term sustainability. Good management can overcome an array of temporary problems, while bad management can lead to the collapse of even the most promising business.
While liquidity, basic solvency, and operating efficiency are all important factors to consider in evaluating a company, the bottom line remains a company's bottom line: its net profitability. Companies can indeed survive for years without being profitable, operating on the goodwill of creditors and investors, but to survive in the long run, a company must eventually attain and maintain profitability.
The best metric for evaluating profitability is net margin, the ratio of profits to total revenues. It is crucial to consider the net margin ratio because a simple dollar figure of profit is inadequate to assess the company's financial health. A company might show a net profit figure of several hundred million dollars, but if that dollar figure represents a net margin of only 1% or less, then even the slightest increase in operating costs or marketplace competition could plunge the company into the red. A larger net margin, especially as compared to industry peers, means a greater margin of financial safety, and also indicates a company is in a better financial position to commit capital to growth and expansion.
The Bottom Line
No single metric can identify the overall financial and operational health of a company. Liquidity will tell you about a firm's ability to ride out short-term rough patches and solvency tells you about how readily it can cover longer term debt and obligations. Efficiency and profitability say something about its ability to convert inputs into cash flows and net income. All of these together, however, are necessary to get a complete and holistic view of a company's stability.