How to Analyze A Company’s Financial Strength

How to Analyze A Company's Financial Strength

When analyzing a business, it is critical to determine its financial position. The financial position refers to the ability to meet long- and short-term obligations. The financial position is determined by analyzing the balance sheet and income statement. The subject of financial position is extensive and only an overview of the topic will be discussed. There are seven key ratios that help investors determine a business’ financial position. To illustrate the application of these ratios, figures from Tempur-Pedic International (TPX) will be used.

Current Position . . .
The current position refers to a business’ ability to meet its short-term financial obligations. Short-term is defined as one year or less. Three key financial ratios help investors determine a business’ current position.

Current Ratio
The current ratio is a business’ current assets divided by current liabilities. Current assets are cash and equivalents. Current liabilities are debts repaid within one year. Investors use the current ratio to determine a business’ short-term financial position. A current ratio of one or greater means a business can satisfy its current liabilities. The higher the current ratio, the more liquid a business. A current ratio of less than one means a business cannot satisfy its current liabilities without additional funds.

Example – In Q1 of 2008, TPX’s current assets ($340,190,000) divided by current liabilities ($123,060,000) was 2.8 (industry average was 2.2). For every dollar of current liabilities, TPX had approximately three dollars of current assets to satisfy them, if needed.

Quick Ratio
The quick ratio is a business’ current assets less inventory divided by current liabilities. Investors use the quick ratio to determine a business’ ability to meet its current liabilities with its most liquid assets. The quick ratio is more conservative than the current ratio because inventory is excluded (inventory is the least liquid current asset). A quick ratio of one or greater means a business can meet its current liabilities. The higher the quick ratio, the more liquid a business. A quick ratio of less than one means a business cannot satisfy its current liabilities without additional funds.

Example – In Q1 of 2008, TPX’s current assets ($340,190,000) less inventory ($112,000,000) divided by current liabilities ($123,060,000) was 1.9 (industry average was 1.6). For every dollar of current liabilities, TPX had approximately two dollars of quick assets to satisfy them.

Working Capital Ratio
Working capital is a business’ current assets over current liabilities. Working capital represents the ability to conduct and expand operations (i.e., liquidity). A business cannot meet its short-term financial obligations if it has negative working capital. Working capital also represents the efficiency of a business. Capital invested in inventory cannot be used until it is converted into cash and collected. The amount of working capital necessary is determined by the character and volume of a business. Working capital divided by revenue is the ratio used to compare businesses.

Example – In Q1 of 2008, TPX’s current assets ($340,190,000) less current liabilities ($123,060,000) was $217,130,000. TPX’s working capital ($217,130,000) divided by revenue ($247,220,000) was 88% (no industry average, but Sealy was 12% and Select Comfort was -46%, so TPX was more efficient/liquid).

Long-Term Position . . .
The long-term position refers to a business’ ability to meet its non-current financial obligations. Long-term is defined as one year or greater. Four key financial ratios help investors determine a business’ long-term position.

Debt-Equity Ratio
The debt-equity ratio is a business’ total liabilities divided by owner’s equity. Investors use the debt-equity ratio to determine the amount of financial leverage used by a business. A debt-equity ratio of one or greater means the majority of a business’ assets have been acquired through debt. The higher the debt-equity ratio, the less liquid a business. A debt-equity ratio of less than one means the majority of a business’ assets have been acquired through equity (if a business was liquidated, owner’s equity could satisfy total liabilities).

Example – In Q1 of 2008, TPX’s total liabilities ($750,390,000) divided by owner’s equity ($70,240,000) was 10.7 (industry average was 31.3). If TPX was liquidated, owner’s equity could not have satisfied total liabilities. However, TPX’s debt-equity ratio was lower than the industry average.

Debt-Equity Ratio (Long-Term Liabilities)
Investors also use a modified version of the debt-equity ratio when analyzing a business or investment. The modified version of the debt-equity ratio is a business’ long-term liabilities (versus total liabilities) divided by owner’s equity.  Example – In Q1 of 2008, TPX’s long-term liabilities ($627,330,000) divided by owner’s equity ($70,240,000) was 8.9 (industry average was 22.1).  If TPX was liquidated, owner’s equity could not have satisfied long-term liabilities. However, TPX’s debt-equity ratio was lower than the industry average.

Interest Coverage Ratio
The interest coverage ratio is a business’ operating income divided by interest expense. Investors use the interest coverage ratio to determine a business’ ability to pay the interest expense on its total liabilities. A interest coverage ratio of one or greater means a business can satisfy it interest expense. The higher a company’s interest coverage ratio, the better. An interest coverage ratio of less than one means a business cannot satisfy its interest expense, so it would be deemed a riskier investment.

Example – In Q1 of 2008, TPX’s operating income ($29,330,000) divided by interest expense ($7,690,000) was 3.8 (industry average was .61). For every dollar of interest expense, TPX had approximately four dollars of operating income to satisfy it, if needed.

Inventory Turnover Ratio
The inventory turnover ratio is a business’ cost of goods sold divided by inventory. It measures the number of times a business sells its inventory. It determine a business’ efficiency in converting inventory into cash. Example – In Q1 of 2008, TPX’s cost of revenue ($139,140,000) divided by inventory ($112,000) was 1.2 (industry average was .21). TPX turned its inventory one time in Q1, while the average inventory turnover for the industry was approximately 25%. TPX was more efficient than the industry with its cash and inventory management.

In addition to financial position, several other factors should be analyzed by an investor before a business or equity is purchased. These factors include: book value, durable competitive advantage, intrinsic value, management, net margin, owner earnings, return on equity, etc. These factors will be the subject of future posts.

All contents copyright © 2008, Josh Lowry. All rights reserved.

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2 Responses to How to Analyze A Company’s Financial Strength

  1. Concetta Daley says:

    Excellent article. Very well written and to the point!

    Like

  2. Virginia Quilen says:

    This is a really useful post. You are a very skilled blogger.

    Like

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