No financial ratio should be looked at in isolation, as weaknesses in some may be offset by strength in others. An understanding of each of these factors will help investors to perform a total diagnostic of a company’s health and therefore its exposure to financial risk.
1. Strong operating cash flow
The lifeblood of any business, cash flow from the business operations must be positive and provide liquidity.
Look for the company’s cash flow from operations in the “statement of cash flows” to be positive – and ideally around 20 per cent of short-term debt (i.e. less than 12 months).
2. Manageable debt levels
Businesses have to pay the ferryman one day. If the burden is too high, the risks are immense.
Look for the company’s debt to be no more than half its tangible asset base. Another measure is the debt-to-equity ratio, with a 50 per cent result requiring a review of a company’s liquidity. These figures can be obtained from the company’s “statement of financial position”, otherwise known as the balance sheet.
3. The right debt balance
Businesses must manage the timing of when the debt is due to avoid extreme pressure from short-term maturities.
Look at the balance sheet and identify the “current liabilities” (debts due within 12 months). Then compare them with the non-current liabilities (due for payment beyond 12 months). Short-term debt ideally should be no more than 60 to 70 per cent of total debt.
4. Solid retained profits
The cheapest and safest form of business funding is profit the company has banked.
Look in the balance sheet for the company’s retained profits figure. This figure should be positive and the higher the better, but not too high – investors don’t like companies that don’t put their profits to work.
Many investors may have become sceptical of profit figures due to “creative accounting”. But the fact is, few businesses that generate consistent profits go broke.
Compare a company’s profit found in the “statement of comprehensive income” (otherwise known as the profit-and-loss statement) to its current short-term debt obligations. Ideally, profits should at least cover 20 per cent of outstanding obligations.
Source: Lincoln Indicators