Financial Health

Once we've figured out how fast (and why) a company has grown and how profitable it is, we need to look at its financial health. Even the most beautiful home needs a solid foundation, after all.

The bottom line about financial health is that "when a company increases Its debt, it increases its fixed costs as a percentage of total costs. In years "when business is good, a company with high fixed costs can be extremely profitable because once those costs are covered, any additional sales the company makes fall straight to the bottom line. When business is bad, however, the fixed costs of debt push earnings even lower.

Look at what debt does to the earnings volatility of the creatively named Acme (see Figure 6.6). With more debt, Acme's earnings fluctuate a lot: They're up more in good times and down more in bad times.

A common measure of leverage is simply the financial leverage ratio that "we used in calculating ROE, equal to assets divided by equity. Think of financial leverage like a mortgage—a homebuyer who puts $20,000 down on a $100,000 house has a financial leverage ratio of J. For every dollar in equity, the buyer has SJ in assets.

The same holds true for companies. In 2OO2, home improvement retailer Lowe's had a financial leverage ratio of 2.1, meaning that for every dollar in equity, the firm had $2.10 in total assets. (It borrowed the other Si.io.) A financial leverage ratio of 2.1 is fairly conservative, even for a fast-growing retailer. It's when we see ratios of 4, 5, or more that companies start to get really risky.

In addition to financial leverage, make sure to examine a few other key metrics when assessing a company's financial health.

This is just what it sounds like—long-term debt divided by shareholder's equity. It's a little like the financial leverage ratio, except that it's more narrowly focused on how much long-term debt the firm has per dollar of equity.

This one requires a little more work to calculate, but it's worth it. Look up pretax earnings, and add back interest expense—this gives earnings before

Acme: Conservatively financed with a little debt.	2002	2003 Hypothetical Scenarios: Good Year (Sales up 20%)	Bad Year (Sales down 20%)
Sales Grass profit Less: Interest Expense	5,000 1,000 200	6,000 1,200 200	4,000 800 200
Earnings before taxes Less: Taxes (35% rate)	800 280	1,000 350	600 210
Net income	520	650	390
		Pro) its up 25%	Profits down 25%
Acme: Aggressively financed with a lot of deb t.	2002	2003 Hypothetical Scenarios: Good Year (Sales up 20%\|	Bad Year (Sales down 20%)
Sales Gross profit Less: Interest Expense	5,000 1,000 GOO	6,000 1,200 GOO	4,000 800 GOO
Earnings before taxes Less: Taxes (35% rate)	400 140	600 210	200 70
Net income	260	390	130

interest and taxes (EBIT). Divide EBIT by interest expense, and you'll know how many times (hence the name) the company could have paid the interest expense on its debt. The more times that the company can pay its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.

For home improvement retailer Lowe's, for example, we add $182 million in interest expenses to $2.36 billion in pretax earnings to get $2. 54 million in EBIT, and we divide $2.54 million by the $182 million in interest expense to get times interest earned of 14. In other "words, Lowe's earned enough money in 2003 to cover its interest obligation 14 times over, which is a pretty safe margin (see Figure 6.7).


Lowe's Companies: Partial Income Statement
Year ending January 31	2003
Net sales	$26,491
Cost of sales	18,465
Gross margin	8,026
Expenses:
Selling, general, and administrative	4,730
Store opening costs	129
Depreciation	626
Interest	182
Total expenses	5,667
Pre-Tax Earnings	2,359
Income tax provision	888
Net earnings	$1,471

It's tough to say precisely how low this metric can go before you should be concerned—but higher is definitely better. You want to see higher times interest earned for a company with a more volatile business than for a firm in a more stable industry. Be sure to look at the trend in times interest earned over time, as well. Calculate the ratio for the past five years, and you'll be able to see whether the company is becoming riskier—times interest earned is falling—or whether its financial health is improving.

The current ratio (current assets divided by current liabilities) simply tells you how much liquidity a firm has—in other "words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities. As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble.

Unfortunately, some current assets—such as inventories—may be worth less than their value on the balance sheet. (Imagine trying to sell old PCs or last year's fashions to generate cash—you'd be unlikely to receive anything close to what you paid for them.) So there's an even more conservative test of a company's liquidity, the quick ratio, which is simply current assets less inventories divided by current liabilities. This ratio is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories. In general, a quick ratio higher than 1,0 puts a company in fine shape, but always look at other firms in the same industry to be sure.