This question has always seemed to rattle around in my mind when seeing a solid company show week stock prices. Unfortunately, the answer is not so simple either when talking about financial performance. A company can be performing well on many fronts but have way too much debt/liability. It intrigues me how a financial analysis can tell a lot about how a company operates. A word of advice, if you’re about to go work for a publicly traded company, look at their financials to tell if they’re solid or not…..you’ll thank yourself later.
A companies short term solvency means their ability to pay bills in the short run (6 months or less). This is an indicator how strong they would be if they got into a pinch and if they can keep the doors open. It’s worth understanding the ratios in order to analyze a company because so much depends on it:
Current Ratio= Current Assets/ Current Liabilities. (These are found on the balance sheet)
Let’s say a company has one-million dollars in current assets, eight-hundred thousand dollars in current liabilities and two-hundred thousand in equity. The Balance sheet means balance because each side needs to equal each other. (Assets=Liabilities + Shareholders Equity). Using the Current Ratio equation, this will mean 1M/800K=1.25. This will mean for every dollar of current liabilities, the company has 1.25 dollars of total assets. So the company would be able to pay off its debts by selling assets if it got into trouble financially.
Quick Ratio= Current Assets-Inventory / Current Liabilities
This is a measure of how can pay for its debts without having to sell of inventory (which is a the bloodline of any business). Using the same figures above, let’s say the company has $100K in Inventory. 1M-100K/ 800K = 1.125. This means for every one dollar of current liabilities, the company has 1.13 dollars of current assets. This basically means the company will be able to pay for it’s liabilities without having to sell of its profit making items. In other words, McDonalds would not have to give their hamburgers to the creditors to pay off their debts, they would be able to keep them and continue selling them for revenues.
Cash Ratio=Cash/ Current Liabilities
This is my favorite because it tells just how solvent or liquid a company truly is. Being too liquid/solvent is sometimes not a good thing because it means the company has cash to use which can be invested or used to pay off debts. Let’s say this company has $200K in Cash. $200k/800K= 0.25. This means for every one dollar of current liabilities, the company only has 25 cents of cash. This can spell trouble for the company because they cannot afford their debts with the cash they have on hand. I guess investors look at the law of diminishing returns because too much of one thing can result in negative returns.
I will only touch on the following ratios here because these are very important when trying to understand a companies long term ability to handle their debts.
Total Debt Ratio= Total Assets- Total Equity/ Total Assets.
Total Assets minus Total Equity will equal Total Liabilities because (Assets=Liab + SH Eq –> Liab= Assets – SH Eq). Let’s say the company has 4 million in total assets, 3 million in total liabilities and 1 million in total equity. This will result in the following: 4M-1M/4M = 0.75. This means for every one dollar of total assets, the company has 75 cents of liability. Interestingly enough, when looking at the top 4 banks established and headquartered in Louisiana, the best performer was around 0.87 and the worst was at .912. Banks are highly leveraged because they loan out money to make profit off of interest payments from lenders.
Profit Margin= Net Income/ Sales
This shows a company’s ability to manage its costs and still turn a profit. From an investor standpoint, this one is very pivotal in deciding if the company has the ability to pay dividends to you and other shareholders. Netflix for example over the past 5 years had the following profit margins:
2011. 2012. 2013. 2014. 2015
7.06%. 0.47%. 2.57%. 4.85%. 1.80%
So we can easily see Netflix has struggled to do well over the past 4 years. In other words, their costs were very high and they did bring back money for the shareholders, just not a lot. I would’ve loved to have compared Netflix to Amazon Prime, but Amazon Prime is not a separate entity from Amazon. Whenever looking at investing in stocks, you should compare a company to its competitors and determine who is performing better as a whole.
The interesting thing is Netflix had around a 14% drop in share price the other day even though their earnings were better than the market predicted; however, they underperformed on their subscriptions and the market did not like it at all. Even with strong earnings, a company can suffer because market perception shows lack of confidence.
Hopefully performing your own financial analysis of companies can help you decide where you would like to work or even companies you want to invest in.