How to analyze the financial health of a company in 6 easy steps?

The people in suits running the company, the ones allowing the company to use their money and the outside owners-the shareholders or clients and suppliers of the business, all would want to know the Financial Health of the company. The purpose may be different. But a few basics are common.

The ‘profit’ item at the bottom of the financial statements can be counted as an indicator of whether a company is ‘financially’ healthy or not. Many do consider that- as long as the company is churning out profits, it is a good company. Is that enough? There are many more financial metrics to gauge this.

The Financial Health of a company must be viewed from different viewpoints to get better results. A combination of Inventory, Accounts Receivable, Working capital, Net Income, Sales, Fixed assets, the operating environment and more, all should be considered.

This can be a lot more of to-do and tedious job, but can be simplified in the following six steps:

1 Collect and arrange the financial data

First of all, there should be ‘data’ which can then be analyzed. Annual, quarterly, half yearly and monthly reports are published by the listed companies and get be asked from other firms as well. Among all, the most important statements are:

  • Balance Sheet
  • Income Statements
  • Cash Flow Statements

Other statements like Management Discussion and Analysis, Auditor’s Report, Tax returns, etc. for the last two to three years should be scanned through.

Have them all in Excel.

Financial data from these statements is used mark the trend through the years and to calculate ratios which fall under various categories mentioned below.

2  Profitability

A lot of time is spent on collecting the data and arranging them. But now Excel does it all.

The first measure that comes to mind is whether the company is making profits or not? If yes, how much? Has it always been a profitable company? How many loss making years has the company had?

Answers to all these questions will lead you to forecasting the company’s ability to make profits in the future.

The following ratios will help to evaluate this:

  • Gross Margin Ratios = Gross Profit / Revenues
  • EBITDA Margin = EBITDA / Revenues
  • Net Profit Margin= Net Profit / Revenues
  • Return on Assets = EBIT * (1-Tax rate) / Total Assets

These four together are called the Profitability ratios.

As we compare financial statements of 3-5 years, comparing these ratios over the same period also give a clearer view of the Financial Health of the business.

3  Liquidity

This is not the equity stock liquidity, that can easily can the company’s share can be sold at a fair price. Here we measure the liquidity within the company.

Does the company keep enough cash as its working capital? Or does it have too much in hand? Short term investments-long term investments: how much is the balance between them? Can the company take in business and investment opportunities within convinced time? How much of the company’s cash or easily convertible assets can help cover the debts of the company?

The liquidity of the company can be measured by:

  • Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio = (Current Assets – Inventories) / Current Liabilities
  • EBITDA / Interest paid
  • Cash Flow from Operations / Current debt

4  Cash flow

If the company is generating good revenues, is it further using it efficiently? Is the company paying its suppliers on time? Is it receiving cash in sufficient time? Is too much invested in fixed assets? Can the company cut down its operational expenses?

The movement of cash in and out of the company is an important factor to take note of.

A big number in accounts receivables may affect the growth of a business as money which is to come, is stuck and the company may have to opt for outside borrowings and bank loans, which again comes with a cost. Look out for relative indicators like the accounts receivables turnover, credit policy of the company, etc.

A few ratios to be calculated for this purpose:

  • Operating Cash Flow / current liabilities
  • Operating Cash Flow / sales
  • Free Cash Flow / Operating Cash Flow
  • Operating Cash Flow / Total assets
  • Operating Cash Flow / Long term debt

5  Business operations

We often come across over-priced bills. The actual cost may be low and in books, a higher price is recorded. Sometimes for tax benefits, sometimes personal benefits of an employee or manager.

In business operational analysis, one must scrutinize such malfunctions and corruptions. The production methods, the operational and product certifications (especially in food and pharmaceutical), workplace conditions, input costs, inventory management, etc. are issues to be gone through.

If the company is in a product based business, how much inventory balance does it keep? Excess or insufficient? If a company has too much inventory, either it is falling back in the production process or sales.

This part places a greater impact on the Financial Health of the company.

6  Leverage

Any company, definitely needs capital to run. There are many ways a company raises capital for its business- equity (public, private), debt (bank loans, bonds). It all comes with its own costs and pressure on the management. Thus, a balance, between how much of what to borrow, should be maintained.

Ratios:

  • Total debt / equity
  • Total debt / total Capital
  • Total liabilities / Total assets
  • Total debt / EBITDA

 Comparing the company’s performance numbers with benchmark and the overall industry performance is very crucial while concluding. Because the big figures in the stupendous financial statements can boggle one’s mind. And decision making would also become difficult.

Hence, Financial Models are used. This helps in finding financial data quickly and also in the calculation of all the ratios. Financial Models simplify analyzing, strategy and decision making process.