Financial health analysis (FHA), as the word says, is how to determine the financial health of a company.
The analysis is primarily performed by the management of companies to assess the business sustainability of its suppliers.
The overall health of a supplier sheds light on how well it will do in the short term and whether it will be able to honour the supply agreements.
For example, Apple has a business agreement with 320 suppliers.
At periodic intervals, the financial manager of product sourcing (procurement) team checks the financial health of its suppliers to assess whether a supplier would be able to honour the supply agreement of the products.
The company also does FHA while entering into an agreement with a new supplier.
FHA is also now done by independent Supplier Assessment companies.
The Financial Analyst in these companies does FHA for the suppliers of a company (such as Apple) and provides the analysis to the financial manager, who can take the decision for existing or new supply agreement.
So, how does a financial manager or financial analyst does FHA?
Here’s the process:
The FHA can be done by understanding financial performance with respect to industry performance.
However, looking at large sets of financial data for the company and its peers can be overwhelming.
Also, taking a strategic decision for a supply agreement just based on the looking at the financial performance could be difficult.
Hence, we will prepare a simple model to deduce a score to depict the financial health of a company.
The model will help you to understand the process carried out in calculating the score, which you can also compare historically to deduce the improvement or deterioration in the financial health of the company.
For example, if a supplier score has deteriorated over the period and has entered into a red zone (say less than 30%), the company can negotiate the terms with this supplier.
Similarly, you can look at the score of a supplier, with respect to the other suppliers, while entering into the new contract.
The assessment of FH can be done by analyzing the performance under four broad categories:
- Cash Flow
We will calculate a score of these categories after analyzing the financial ratios under each of these categories.
In our article, we will take the case example of Cisco Systems. We will calculate the Peer benchmark score, which will help understand the financial health of Cisco relative to its peers. We have chosen the following peers of Cisco for our analysis: Motorola Solutions, Juniper Networks, Brocade Communications, and Finisar Corporation.
The below steps will help to calculate the aggregate score to assess financial health.
6 Steps to Determine the Financial Health of a Company
1. Prepare the data
The financial data to analyze the financial ratios can be sourced from the filings of a company.
Please source the following financial items from the financial statements like income statement, balance sheet and cash flow statement of the financial statement. For the purpose of ratio calculation, source 2 years of historical data for each of the peers.
Figure 1: Historical data for Health analysis
2. Calculate Profitability Score
The profitability of the company can be analyzed by calculating the following ratios for the company and its peers.
a) Gross Margin
This ratio indicates how profitable a company is at the most fundamental level and is calculated as:
= Gross Profit / Revenues
b) EBITDA Margin
This ratio indicates what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. and is calculated as:
= EBITDA / Revenues
c) Net Profit Margin
This ratio indicates how much profit a company makes for every dollar it generates in revenue and is calculated as:
= Net Profit / Revenues
d) Return on Assets
This ratio indicates how efficiently the management using its assets to generate earnings and is calculates as:
= EBIT x (1-Tax Rate) / Total Assets
Once the ratios are calculated for Cisco and its peers then set up the table as shown in Figure 2 to calculate the Profitability Score.
In order to calculate the Profitability Score, we will first assign the weight to each of the ratios and then calculate the score for each of the ratios.
We will then multiply the weight and score of each ratio and add them to calculate to the Profitability Score.
The weight of a ratio is assigned by understanding the relevance of that ratio relative to its peers.
The idea is that the ratio and the financial (used to calculate that ratio) should be comparable across the companies.
If the financial item is not comparable, you should try to adjust for unusual or extraordinary items to make it comparable and then calculate the ratio for comparison purpose.
If you are not able to make the desired adjustment (due to lack of disclosures) then either choose a different ratio or assign that ratio low or nil weight.
For example, if the net profit of the company (that you are analyzing) is negative and of all peers is positive, then you should find the reason for negative profit.
If the disclosures are available, then you should adjust the net profit to make it comparable.
If the disclosures are not available, then either choose a different ratio (such as EBIT Margin) or assign Net Profit Margin 0% weight and distribute the weights to other ratios.
Similarly, if the company that you are analyzing has less debt on its balance sheet as compared to its peers, then the leverage position or debt ratios will not be comparable. Hence, assign less weight to the leverage category and debt ratios (for example, Total Debt to Equity) and coverage ratios (Interest coverage).
For our example of Cisco in Figure 2, we have assigned less weight to EBITDA margin and Return on Assets, because the ratios are very near to the boundaries (minimum and maximum) of peer average.