Looking Into A Company's Financial Health

Looking Into A Company's Financial Health

Posted by lionel319 @ Tue 02 Mar, 10,

After looking at all the reasons for investing in a particular stocks (Step #1 - #4), we now look for reasons for NOT investing in a particular stock.

No matter how good the stock's industry is,
No matter how wide the company's moat is,
No matter how good it's growth and profitability is,
If it is sick .... financially, there is no guarantee that it's gonna survive the next wave of influenza.

Ok. So how do I look at a company's financial health?

 



Basically, I look at a company's financial health the same way as I look at a normal person's balance sheet.
These are the 2 golden questions that you should be asking:-

• Is the company capable of paying of it's Short Term Interest(Installment) obligation?
• Is the company capable of paying back it's Long Term Debt?

Let's go through the above 2 points with a case study by looking into a balance sheet of a normal person, a working employee, an engineer, PinkPig, with a net saving of $2000 a month after deducting all basic expenses(food, accommodation, rental, etc)  and other loans (study loan etc).

Let's say, PinkPig just bought a new car, which cost $100k.
He puts up 10% as down payment ($10k), and took a $90k loan from the bank.
He needs to pay $1875/= as monthly installment to the bank.

So far, this is the information that we've got:-

PinkPig's annual savings	$24,000 ($2000 salary x 12 months)
PinkPig's annual Installment obligation	$22,500 ($1875 monthly installment x 12 months)
PinkPig's total Long Term Debt	$90,000 (loan from bank)

Now, let's start drilling into PinkPig's financial health by asking the above 2 golden question, using these financial metrics:-

---

1. Long Term Debt Payback Time

Long Term Debt Payback Time = Long Term Debt / EBIT

This is basically a measure so that we get a feel of whether the company is REALLY capable of paying back all it's debt that it is owing the bank.

For PinkPig's case:-
- PinkPig owes the bank Long Term Debt of $90k.
- PinkPig's Annual Savings (EBIT) is $24k.

If PinkPig were to save up all his annual savings, how long will it take pinkpig to repay the total loan?
$90k / $24k, and we get around 3.75 years.
Anything which spans around 5 years or so is still an acceptable (and comfortable) number for me.
The key to this is just to have a feel whether the company is really capable of repaying back the Long Term Debts if they were to use up all it's Net Income into repaying their loans.
If you want to have a feel of what it looks like, take a look into Ford Motor's Financial Health here. 
In year 2009, Ford had a net income of $2 Billion.
You might say "WOW!!!"
Wait till you take a look at it's Long Term Debt .... which is standing at a whooping $133 Billion.
It takes Ford at least 66 freaking years to pay back it's Long Term Debt, by plowing back all it's net earnings into the bank.
And this is by assuming that Ford is capable of earning $2 Billion year in and year out, no matter what.




2. Times Interest Earned (Interest Coverage Ratio)
 (EBIT = Earnings Before Income-Tax)

PinkPig's Times Interest Earned(TIE) is
= PinkPig's Annual Savings / Annual Installment
= $24,000 / $22,500
= 1.067


The golden question number 1:-

• Is PinkPig capable of paying of it's Short Term Interest(Installment) obligation?

Yes. He is capable. Only if nothing unusual happens to him.
If something were to happen to him, and his saving drop by a mere 10% to  $21,600, he will have problem with that.
Either he will have to sell of something to repay the bank installment, or he will have his car confiscated back by the bank.
This is very crucial to companies, especially those that can't meet their short term debt obligation.
The only way for them to meet this short term obligation is to liquidate their assets, which will in turn eat into their core business, and eventually affect their long term business growth.
We definitely do not want to be put into a nasty situation like that.
Look for a TIE ratio which is pretty high.
The higher the better.
A company which has a TIE ratio of 10x means that it is capable of meeting it's short term obligation even if it's earnings were to drop 10x due to any unforeseen disaster (eg:- economy crisis).
Once a company is seriously wounded, it's really hard for them to be able to regain back their previous glory, not to even mention about fending of competitors and defending their once-used-to-be-market-leader status.
 

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