Long-term investors depend on their stocks to remain viable during economic recessions. In today’s Coronavirus Pandemic, businesses of all sizes are losing income from the forced reduction of consumer spending, which may destabilize companies to the brink of bankruptcy. Investors can assess stability by reviewing the financial health of their companies.
Financial health is the ability to pay all obligations in a timely matter. Credit ratings and analyst reports use propriety methods to measure financial health. You can independently rate the financial health of a public company using a single numerical score from 0 to 10 based on liquidity and solvency; the higher the score, the healthier the company (eq. 1).
equation 1: Health = Liquidity + Solvency
Liquidity refers to the ease of converting current assets into cash for payments of current liabilities. Current assets are considered convertible to cash within one year. Some assets are more liquid than others. Savings accounts, checking balances, money market funds, and receivables [i.e., customers’ IOUs] represent liquid assets. Inventory [i.e., unused supplies and unsold products] is considered an illiquid asset. Current liabilities are the costs of paying business expenses such as wages, payables, and interest on short-term credit. The following ratios provide useful measurements of liquidity:
- Current ratio = Current assets / Current liabilities.
- Quick ratio = (Current assets – Inventory) / Current liabilities
- Interest coverage = EBIT / Interest [EBIT is the company’s earnings before accounting for the charges of interest and tax; EBIT is a measure of recurring income]
Solvency refers to the liquidation value of a company in case the company must pay all of its short-term and long-term liabilities. I use the shareholders’ equity [aka net worth or book value] as a common denominator for the measurement of solvency. Solvency ratios and free cash flow provide useful measurements:
- Debt-to-Equity = Long-term debt / Shareholders’ equity.
- Financial Leverage = Total assets / Shareholders’ equity.
- Free Cash Flow = Operating cash flow – Capital expenses
Chart 3 displays health scores for a list of companies identifiable by stock tickers; they are the current holdings of my investment club. The data were calculated with the formula in eq. 1 using open source data for liquidity and solvency. Three stocks received low health scores of 2.
From chart 3, I selected five strong competitors of VZ and CMCSA to determine if the low health score represents a larger group of 7 competitors listed in the trading sector of Communication Services. The additional competitors are listed below in chart 4. Three of the additional competitors matched the scores of CMCSA and VZ, inferring that most companies in that select group operate with low liquidity and solvency.
Another comparison was made using a sample of stocks with an open-source, proprietary grade of low financial health (chart 5). One stock, JCP, recently filed for chapter 11 bankruptcy.
The health scores in chart 3 are based on historical data at least 3 months old. Stocks with the lowest scores are considered more unstable. If, in your informed opinion, there’s a credible risk of bankruptcy and delisting, you can protect your investment by either selling the stock or placing a stop-loss order on it.
Open-source financial data can be used to assess the risk of potential bankruptcy and delisting among publicly traded stocks, especially during an economic recession. Combined assessments of liquidity (chart 1) and solvency (chart 2) additively form a health score of 0 to 10, with lower scores implying poor financial health. The scoring system is easy to implement, but unreliably predicts financial failure of public companies with low scores. Additional fundamental analysis of the company is strongly recommended and meanwhile, if you wish to protect your investment from a substantial loss, place a temporary stop-loss order on the holding.
Copyright © 2020 Douglas R. Knight