How to Measure a Company’s Financial Strength
The logic behind the assets/liabilities relationship of a company whose stock you are considering investing in is the same as that of your own household. When you look at a snapshot of your own finances, how can you tell whether you’re doing well? Odds are that you start by comparing some numbers. The most appropriate way to do this is to compare net worth over time.
Compare a company’s balance sheet at a recent point in time to a past time. You should do this comparative analysis with all the key items on the balance sheet to see the company’s progress (or lack thereof). Is it growing its assets and/or shrinking its debt? Most important, is the company’s net worth growing? Has it grown by at least 10 percent since a year ago?
All too often, investors stop doing their homework after they make an initial investment. You should continue to look at the firm’s numbers regularly so that you can be ahead of the curve. If the business starts having problems, you can get out before the rest of the market starts getting out (which causes the stock price to fall).
To judge the financial strength of a company, ask yourself the following questions:
Are the company’s assets greater in value than they were three months ago, a year ago, or two years ago? Compare current asset size to the most recent two years to make sure that the company is growing in size and financial strength.
How do the individual items compare with prior periods? Some particular assets that you want to take note of are cash, inventory, and accounts receivable.
Are liabilities such as accounts payable and debt about the same, lower, or higher compared to prior periods? Are they growing at a similar, faster, or slower rate than the company’s assets? Debt that rises faster and higher than items on the other side of the balance sheet is a warning sign of pending financial problems.
Is the company’s net worth or equity greater than the preceding year? And is that year’s equity greater than the year before? In a healthy company, the net worth is constantly rising. As a general rule, in good economic times, net worth should be at least 10 percent higher than the preceding year. In tough economic times (such as a recession), 5 percent is acceptable.