# Understanding Financial Health

First, let's take a moment to define what we're trying to measure. Financial health measures tell us whether a company can survive a serious downturn in business, whether related to competitive pressures, general recession in the overall market, natural or man-made disasters, or even just poor management. A company with good financial health can survive these challenges, and even take market share over weaker rivals during them. A company with poor financial health could find itself at court filing for bankruptcy protections.

1) Coverage Ratio

__What does it tell you?__

The number itself tells you how many times over the company covers net debt interest with operating profits.

__How do you calculate it?__

Operating Earnings (EBIT) / (Interest Expense - Interest Income)

__What's good or bad?__

If the denominator of the equation is negative, this ratio simply tells you the company has no net interest expense, which indicates excellent financial health.

If it is not, the ratio gives us an idea of how much debt interest weighs on the company's profits. The lower the number, the higher debt interest burden a company has to cover. A company with a number under 3.0 is carrying too much debt. At MagicDiligence, we like to see a 7.0 or above coverage ratio... and the higher, the better.

__Simple example__

Financial health is easy to understand in the context of personal finance. Imagine you have a mortgage in which interest every month is around $1,000 and a car payment where monthly interest is around $50. Some of this is mitigated by the $50 in interest earned from a savings account (making net interest $1,000). Your take-home paycheck every month is about $4000, making your personal coverage ratio (4000 / 1000), or 4.0.

2) Debt to Equity Ratio

__What does it tell you?__

A company creates it's earnings using two things. Equity is what the company owns outright, and debt is of course money the company borrowed to make purchases. The debt to equity ratio simply compares the two and gives you the debt side of the equation.

__How do you calculate it?__

Total Long Term Debt / Total Equity

__What's good or bad?__

The father of value investing, Benjamin Graham, liked to see less than 50% debt to equity (0.500). The best number possible is 0 - this is a company carrying no debt. MagicDiligence does not set a hard limit for debt to equity because the reliability of cash flows affects what is acceptable, but generally anything over 0.750 is frowned upon.

__Simple example__

Banks often use your personal debt-to-equity as a component of deciding whether or not to lend you money (this is what they use the reams of documents requested from you for). For example, the amount you owe on your house is $180,000 and your car loan outstanding is $7,000 (making total debt $187,000). Your equity in the home and all of your other assets and belongings total $400,000. Personal debt to equity would be (187000 / 400000) = 0.468.

3) Current Ratio

__What does it tell you?__

A simple test of a company's liquidity, or ability to cover short term obligations in the case of a major emergency.

__How do you calculate it?__

Current Assets / Current Liabilities

__What's good or bad?__

Ben Graham gave us another number to shoot for here - 2.0 was considered a strong number for a well prepared company, and this site concurs in general with that figure. A number under 1.0 is a company carrying more obligations than means to meet them, in the short term (this is bad, of course).

__Simple example__

You lose your job and have no means of revenue for a month. In that month, you owe your usual $1700 mortgage payment, $300 car payment, and $1000 in utilities, groceries, and other (in total, $3000 of short term expenses). However, your savings account has a $9000 balance and you can sell about $2000 worth of stuff on eBay in short order, making your current assets worth about $11000. Your current ratio would therefore be (11000 / 3000) = 3.67.

4) Quick Ratio (Acid Test)

__What does it tell you?__

A very minor modification of Current Ratio, Quick Ratio is also a measurement of a company's ability to meet short term obligations in an emergency situation. It removes inventories from current assets, as inventories are unlikely able to be unloaded at full price in a short amount of time.

__How do you calculate it?__

(Current Assets - Inventories) / Current Liabilities

__What's good or bad?__

Again, a 2.0 figure is a strong short term position, while anything under 1.0 is weak.

__Simple example__

Using our example from #3, simply remove that $2000 of stuff you could sell on eBay (what if nobody buys it, or buys it well below what you believe it's worth?). Now the quick ratio is (9000 / 3000) = 3.0.

5) Dividend Payout Ratio

__What does it tell you?__

The percentage of earnings or free cash flow payed out to shareholders in the form of a dividend. It gives the investor an idea of whether a large dividend is "safe" or will have to be cut, and whether the dividend has a good chance of being raised in the future.

__How do you calculate it?__

Textbook: Dividends Paid / Net Income

MagicDiligence: Dividends Paid / Free Cash Flow

where Free Cash Flow = Net Cash From Operations - Depreciation

__What's good or bad?__

Payout ratio over 100% indicates the instability of a dividend... the company is not making enough money to cover it's payout. A payout ratio of 60% of free cash flow is about the maximum amount sustainable for companies this site follows (there are exceptions like REITs and utilities where payout ratios are required to be higher). An average payout ratio is about 30% of free cash flows.

__Simple example__

This one is pretty self explanatory. For the sake of example we'll take Johnson & Johnson, who in 2007 earned 12.5 billion in free cash flow and paid out 4.7 billion in dividends. Payout ratio was then (4.7 / 12.5) = 0.38, or 38%, a healthy and sustainable ratio.

Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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