Checking the Financial Vital Signs

While a company may have a good, sustainable business model that generates a lot of cash, you must also make sure that it's not taking unnecessary risks by overloading itself with debt. It is important to look at the cash on hand and the other current assets in relation to the long term debt and overall liabilities on the balance sheet. If the company does not carry much cash on hand, if a lot of its capital is tied up in inventory, or if it has a large accounts receivable balance in relation to the rest of its current assets, then it might have more difficulty making interest payments in a pinch. Here are some useful ratios to evaluate the financial health of a company:

Quick Ratio

The quick ratio is a simple, conservative way to measure how easily a company can cover its current liabilities with its current, most liquid assets. To calculate the ratio, simply divide the current assets minus inventory by the current liabilities on the balance sheet. Generally, the higher the ratio, the more financially sound the company. A ratio well over 1 is always nice to see. Of course, since the ratio includes the accounts receivable, it is not a perfect indicator. More on this in a bit.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Interest Coverage Ratio

This metric is exactly what it sounds like. It measures how easily a company can make interest payments on its outstanding debt. To calculate this, divide the earnings before interest and taxes (EBIT) by the interest expense, both of which can be found on the income statement. If this ratio is hovering around 1 or below, then it is in serious danger of defaulting on its debt, especially if earnings are erratic.

Interest Coverage Ratio = EBIT / Interest Expense

Inventory, Receivables, and Turnover

Comparing current assets to current liabilities is an easy way to determine the liquidity of a company, but it may not tell the entire story. While cash and short term investments are almost always extremely liquid, the same may not be true of inventory and receivables. In order to determine how efficient a company is at converting its inventory and receivables to cash, we can simply look at the turnover ratios for these two accounts. Simply divide net sales by the average inventory to see how many times over a company's inventory is sold for a certain period. This metric should be compared to its industry average, as different industries turn over their inventory at very different rates (think of a jewelry store versus a Wal-Mart).

Inventory Turnover = Net Sales / Average Inventory

Similarly, dividing net sales by the average accounts receivables will show you how effective a company is at extending credit and collecting debts. Again, a high ratio is good, but should be compared to the industry average.

Receivables Turnover = Net Sales / Average Accounts Receivable

Seeing either of these turnover ratios fall year over year is a red flag as it indicates that a company is becoming less efficient in how inventory and receivables is being converted to cash. Additionally, seeing inventory or receivables increase drastically as a percentage of sales over the years may be a warning sign as well.

Conclusion

While these ratios will cover many aspects of a company's financial health, they are far from complete. Depending on how much time you have or how well you understand accounting, you may choose to further scrutinize a company's financial statements by checking the due dates of certain debt or looking at the inventory valuation method, among other things. Also, it is important to remember that while lower debt and more cash on a balance sheet decreases risk, they may also inhibit growth. If a company is profitable and has promising growth prospects, then taking on a bit of debt and tying up capital in lucrative projects is a good thing. Analyze a company's financials conservatively, but keep the big picture in mind when you do.