Investing in stocks and building a portfolio might seem like an easy task. However, for profitable returns, constant monitoring and tracking is required. The performance of the markets, the industry, the economy, and the entire country will affect the stock’s health. Investors need to stay alert and should conduct a portfolio health check-up regularly.
The Important Factors:
The crucial parameters affecting the stock’s health may not just be inside the company. Several factors are beyond the internal environment and control of the company, which investors need to consider. These may include the country’s government policies, the state of the economy, the level of growth, the state of markets, and much more.
Government Policies play an essential role in the growth of a business. It can change the way companies work and influence the economy either by passing laws or changing its spending or taxes. Taxation policies mainly affect the business costs. The regulatory policies such as restraints on private activities, control of monopoly and big business, socio-economic infrastructure may promote or demote business activities.
Macro-economic factors such as interest rates, inflation, unemployment, and economic growth often move stock markets. Stock markets are always watching out for more economic growth because it usually translates more profits for companies, which in turn tend to grow the value of stocks.
Company’s Fundamentals
The stock price is majorly driven by the company’s future prospects and growth. It is imperative to check for the company’s fundamentals. When evaluating a stock, investors are always searching for that one golden measurement that can be obtained by looking at a company’s financial statements. To accurately assess a company’s financial health and long-term sustainability, investors must consider several financial metrics in tandem. The main areas of economic health are liquidity, profitability, and operating efficiency. Other than these, its management quality and governance, competition, cash flows, and financial risk are some of the factors to be considered for the long sustained growth of the company.
- Profitability and Growth
The health of the company can be measured by looking at its profitability and growth. It is essential to knowing the present condition of any company to create a successful growth strategy. If a company has numerous shortcomings, such as performance, sales, or marketability, a premature attempt to grow can ultimately collapse. Growth is essential for long-term profit and success, whereas profit is key to basic financial survival as a corporate entity.
A good metric for evaluating profitability is net margin, the ratio of net profits to total revenues. It is crucial to consider the net margin ratio because a simple dollar figure of profit is inadequate to assess its financial health. A company might show a net profit figure of several hundred million dollars. Still, if that dollar figure represents a net margin of only 1% or less, then even the slightest increase in operating costs or marketplace competition could plunge the company into the red.
- Operating Efficiency and Liquidity
A company’s operating efficiency is key to its financial success. Operating margin is one of the best indicators of efficiency. This metric not only considers a company’s primary operational profit margin after deducting the variable costs of producing and marketing the company’s products or services, but it also indicates how well the company’s management can control costs.
Liquidity is a crucial factor in assessing a company’s fundamental financial health. Liquidity is the amount of cash and readily convertible to cash assets a company owns to manage its short-term debt obligations. Before a company can prosper in the long term, it must first survive in a short time.
The two most common metrics used to measure liquidity are the current ratio and the quick ratio. Of these two, the quick ratio, also known as the acid test, is the conservative measure.
- Financial Risk
Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.
It is expensive to build a business from the ground up. At some point in any company’s life, the business may need to seek outside capital to grow. The need for funding creates a financial risk- both the business and any investors or stakeholders invested in the company.
Credit risk—also known as default risk—is the danger associated with borrowing money.
Businesses can experience operational risk when they have poor management or flawed financial reasoning. Based on internal factors, this is the risk of failing to succeed in its undertakings.
- Competition
Business competition is the contest or rivalry among the companies selling similar products or having the same target audience to get more sales, increase revenue, gain more market share than others, and inevitable in specific industries. With a high entry barrier, the company could enjoy a business monopoly or even with patents. Once they expire, the company should be strategically planned to face competition and not lose market share in any rivalry firms’ presence. This can be ensured by having good brand value, consumer loyalty, better prices, and quality product and services.
- Management Efficiency and Corporate Governance
While management itself cannot constitute an economic moat, management’s capital-allocation decisions can lead to the establishment, enhancement, or erosion of an economic moat.
Solid and effective corporate governance helps foster integrity, leads to positive performance and a sustainable business overall. It also exists to increase the accountability of individuals and teams within the company, working to avoid mistakes before they can even occur.
Investors should also keep a check on the firms’ legal matters. Companies that are hit with big lawsuits may signal potential red flags and prove unhealthy for your portfolio. Financial Frauds, penalties, and other scams may also prove harmful for the investment, and hence investors should beware of the same
- Cash Flows
A business may see profits, but if its money is tied up in hard assets or accounts receivable, there is no cash to pay employees. Generally, all investors and shareholders of a company want to get some money out of their investment. Hence, information about a company’s receivables and payables is of crucial importance to financial statements.
Checking the Portfolio Health Using MarketXLS:
MarketXLS is a one-stop solution for investors to do a thorough analysis of the company or their portfolio. To do a portfolio health check-up, investors can measure the company’s financial health’s main areas using ratio analysis, which investors can do by just entering the ticker in any cell. MarketXLS will generate a list of essential ratios at once. It also provides fundamental data that includes financial statements in Excel P&L, Balance Sheet, and Cash Flow statements of companies with one click and more than 400 fundamental indicators (US & Canada, Germany, and London Stocks).
- Profitability Ratios
Net Profit Margin: measures the amount of income that a company could generate for each dollar of revenue. A higher level of net profit margin indicates higher profitability and is thus more desirable.
The Gross Profit Margin: measures the gross profit that a company generated for each dollar of revenue. A higher gross profit margin indicates higher profitability and is generally more desirable, although differences in gross profit margins across companies reflect differences in companies’ strategies.
Return on Assets: measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets.
Return on Capital: measures the profits a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity).
- Operating Efficiency and Liquidity
Inventory turnover Inventory lies at the heart of operations for many entities. This ratio indicates the resources tied up in inventory (i.e., the carrying costs) and can, therefore, be used to indicate inventory management effectiveness.
The total asset turnover ratio measures the company’s overall ability to generate revenues with a given level of assets. A ratio of 1.20 would indicate that the company is generating €1.20 of revenues for every €1 of average assets. A higher ratio indicates greater efficiency.
Current ratio expresses current assets in relation to current liabilities. A higher ratio indicates a higher level of liquidity (i.e., a better ability to meet short-term obligations). A current ratio of 1.0 would indicate that its current assets’ book value exactly equals the book value of its current liabilities. A lower ratio suggests less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short-term obligations. Liquidity affects the company’s capacity to take on debt.
Acid Test Ratio or The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets (sometimes referred to as “quick assets”) with current liabilities.
- Financial Risk (Solvency Ratios)
The debt-to-equity ratio measures the amount of debt capital relative to equity capital. A higher ratio indicates weaker solvency.
Financial Leverage Ratio This ratio (often called simply the “leverage ratio”) measures the amount of total assets supported for each one money unit of equity. For example, a value of 3 for this ratio means that each €1 of equity supports €3 of total assets. The higher the financial leverage ratio, the more leveraged the company is to use debt and other liabilities to finance assets.
Interest Coverage This ratio measures the number of times a company’s EBIT could cover its interest payments. A higher interest coverage ratio indicates more robust solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes) from operating earnings.
Bottom Line
Investors must ensure they keep a check on their investments every now and then ensure that their invested companies are in good health. It can do it in many ways, but mainly by evaluating various companies’ financial data and going through the annual reports and other data. Investors can also use several other quantitative metrics to analyze the same. Quite often, collecting and evaluating this data may be a tedious task. With the help of MarketXLS, investors can get all this data and various excel templates to assess the company and do a stock health check at ease.
Disclaimer
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References:
What Is the Best Measure of a Company’s Financial Health?. https://www.investopedia.com/articles/investing/061916/what-best-measure-companys-financial-health.asp
Financial Risk Definition. https://www.investopedia.com/terms/f/financialrisk.asp
The Importance of Corporate Governance https://sprigghr.com/blog/board-management/the-importance-of-corporate-governance/
