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How to evaluate a company's financial health

Investopedia Staff | January 24, 2009

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For companies, being able to meet short-term financial obligations is an integral part of maintaining operations and growing in the future. After all, if it's not able to meet today's debts, a company might not live to see another day! That's why it's essential for investors to know how to evaluate a company's short-term financial health. Here we take you through a few of the ratios that are the foremost tools for doing so.

The basics of liquidity
A large factor determining a company's short-term financial health is liquidity, the definition of which depends on context. In stock trading, liquidity is the degree to which the market is willing to buy a particular stock. As a characteristic of an asset, liquidity refers to the ease with which an asset can be converted into cash. This is the definition of liquidity we are interested in.

Let's compare two different kinds of assets: a building and a money market account. Even if these two assets are valued at $100,000 on a company's financial statement, their liquidities have different implications for the company's short-term health.

The money market account, an asset referred to as a cash equivalent, can be converted into cash within a day or two, if not immediately. The building, however, is very illiquid. For the company to get its cash, it must sell the building, which could take months, if not years.

Essentially, a company's short-term liquidity determines how well it can make its necessary payments (cash outflows) - which include employee wages, interest and supplier costs - given the revenue it generates (cash inflows). If a company has no cash equivalents, its inflows need to match or exceed cash outflows. So, if a company has a bad month and it has no supply of liquid assets like a money market account, it will be unable to make its necessary payments.

The current ratio:

The first ratio we will look at is the current ratio, which compares all of a company's current assets to all of its current liabilities. In general, the term "current" means less than one year. So, current assets include cash, accounts receivable, inventory, prepaid expenses and other assets that can be converted to cash within one year. Current liabilities include short-term debt, interest, accounts payable and any other outstanding liabilities that are due within a year's time.

When calculating this ratio, you are essentially trying to determine whether a company can meet its short-term obligations. It will likely be able to do so if the ratio is above 1; if the ratio is less than 1, the company is likely to fall short. We say "likely" because although a ratio of 1 or greater indicates that the company has more current assets than current liabilities, it may be inappropriate to judge certain industries by a rigid standard.

For industries that generally have a large portion of current assets tied up in inventory, a ratio of 1.5 or even 2 might be a better standard. When analyzing the current ratio, as when looking at any ratio, an investor should make comparisons between companies that operate in the same industry. Different industries have different business needs, so investors must modify their analyses accordingly.

Finally, bigger is not necessarily better in the case of the current ratio. A really high ratio, 10 for example, should probably sound some alarm bells, because it indicates that the company has a large amount of current assets that could - and probably should - be invested back into the company. Although a company with a very high current ratio may be stable in the short term, it probably has no means of sustaining its long-term growth and performance.

The acid test or quick ratio:

The acid test is a more rigorous version of the current ratio. It indicates whether a firm, without selling inventory, has enough short-term assets to cover its immediate liabilities. Companies with ratios of less than 1 cannot pay their current liabilities without selling inventories and should be viewed with extreme care. An acid test that is much lower than the current ratio signals that current assets are highly dependent on inventory - retail is a type of business in which this would occur. In general, a ratio of 1 is considered satisfactory, although, as with the current ratio, the acid test should be compared only within a similar industry.

Interest coverage:

Interest coverage indicates what portion of debt interest is covered by a company's cash flow. A ratio of less than 1 means the company is having problems generating enough cash flow to pay its interest expenses. Ideally, you want the ratio to be over 1.5.

A company with no long-term debt doesn't have any interest expense; this situation causes the current ratio to give enviable results. Companies with a poor interest coverage ratio can improve it by improving cash flow and/or lowering interest expenses by paying off debt.

This ratio is popular not only among investors, but also with creditors, who want to see that a company's short-term health is strong and that the company has sufficient cash flow to make principal and interest payments.

Another notable fact about the ratio is that sometimes different numerators will be used. For example, some analysts or creditors will use EBITDA in place of EBIT.

Activity ratios
There are a few different activity ratios, but essentially, their main function is to help determine the company's cash flow cycle, giving a picture of how efficiently assets are being used. Almost any current account can be analyzed in terms of this cycle, but the three most common activity ratios each measure one of the following:

  • How long a company takes to collect receivables
  • How long a company takes to sell inventory
  • How long it takes to pay suppliers

The calculation of activity ratios is a little complex, but to give you an idea of how these ratios work, we'll look at the activity ratio dedicated to accounts receivable. Suppose that a company has total credit sales of $22 million. At the beginning of the year, accounts receivable is at $4.5 million, and at the end it's $1.5 million. By using the accounts receivable turnover ratio we can determine that the company's receivables turn over at a rate of approximately 7.3 times per year. This means receivables remain outstanding for an average of 50 days. Here the calculations are represented mathematically:

Although we only demonstrate one activity ratio calculation here, the others are calculated in a similar fashion. All it takes is some research into the company and some number crunching.

Let's look at an example to put this all into context. Suppose that the above company has to pay suppliers within 90 days of purchase and suppose that, by calculating another activity ratio, we find the company holds inventory for 80 days.

As the company's accounts receivable remain outstanding for 50 days, we find it has a cash cycle of 130 days (80+50). In other words, from the time it purchases its product from the supplier, the company takes approximately 130 days to collect payment from the customer.

The supplier, however, requires a payment within 90 days of the purchase. This 40-day discrepancy may create short-term liquidity problems for the company. This means investors should conduct more research to determine whether there is justification for this difference, and whether it is likely to cause hardship for the company.

Examining activity ratios and determining a company's cash flow cycle are important elements of determining a company's short-term health and should be analyzed in conjunction with the other short-term liquidity ratios.

By honing in on crucial aspects of a company's financial health, ratios shed light on how well a company will do in the short term. More importantly, they help investors determine whether a company has the stability to get through unexpected problems today. If a company cannot maintain operations in the short term, it will not have the ability to provide investors with any benefits in the long term.

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