Financial Health: Stability Indicators
Growth is great, but not if the company collapses before realizing it. Financial health ensures survival.
What Is Financial Health?
Financial health measures a company's ability to:
- Pay its bills on time
- Service its debt
- Survive economic downturns
- Fund operations without distress
Personal Finance
A financially healthy person:
- Has emergency savings
- Doesn't max out credit cards
- Can pay bills even if income drops temporarily
- Isn't one paycheck away from disaster
Companies need the same stability. Financial health is corporate emergency preparedness.
Key Health Metrics
1. Current Ratio
Formula: Current Assets ÷ Current Liabilities
What it measures: Can the company pay bills due within a year?
| Ratio | Interpretation |
|---|---|
| > 2.0 | Very healthy |
| 1.5 - 2.0 | Healthy |
| 1.0 - 1.5 | Adequate |
| < 1.0 | Potential trouble |
2. Quick Ratio (Acid Test)
Formula: (Current Assets - Inventory) ÷ Current Liabilities
What it measures: Can they pay bills without selling inventory?
More conservative than current ratio—excludes inventory which may be hard to sell quickly.
3. Debt-to-Equity
Formula: Total Debt ÷ Shareholders' Equity
What it measures: How leveraged is the company?
| Ratio | Interpretation |
|---|---|
| < 0.5 | Conservative |
| 0.5 - 1.0 | Moderate |
| 1.0 - 2.0 | Leveraged |
| > 2.0 | Highly leveraged |
4. Interest Coverage
Formula: Operating Income ÷ Interest Expense
What it measures: Can they afford their debt payments?
| Ratio | Interpretation |
|---|---|
| > 10 | Very safe |
| 5 - 10 | Comfortable |
| 2 - 5 | Adequate |
| < 2 | Dangerous |
Key Takeaways
- Current Ratio shows short-term liquidity
- Debt-to-Equity shows leverage level
- Interest Coverage shows debt affordability
- Healthy companies can survive downturns
Cash Flow Health
Free Cash Flow (FCF)
Formula: Operating Cash Flow - Capital Expenditures
Why it matters: This is real cash the company generates after maintaining its business.
Healthy signs:
- Positive FCF consistently
- FCF growing over time
- FCF close to or exceeding net income
Warning signs:
- Negative FCF
- FCF much lower than net income
- Declining FCF trend
Cash Is King
Earnings can be manipulated through accounting. Cash flow is harder to fake. If a company reports profits but burns cash, be skeptical.
"Earnings are an opinion, cash is a fact."
The Altman Z-Score
A famous bankruptcy prediction model:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
- A = Working Capital / Total Assets
- B = Retained Earnings / Total Assets
- C = EBIT / Total Assets
- D = Market Value of Equity / Total Liabilities
- E = Sales / Total Assets
| Z-Score | Interpretation |
|---|---|
| > 2.99 | Safe zone |
| 1.81 - 2.99 | Grey zone |
| < 1.81 | Distress zone |
Health by Sector
Different sectors have different health norms:
| Sector | Typical D/E | Current Ratio | Notes |
|---|---|---|---|
| Tech | 0-0.5 | 2.0+ | Cash-rich |
| Utilities | 1.0-2.0 | 0.8-1.2 | Stable cash flows |
| Banks | 8-12 | N/A | Different metrics apply |
| Retail | 0.5-1.5 | 1.0-1.5 | Inventory-heavy |
| Healthcare | 0.3-1.0 | 1.5-2.5 | Varies by sub-sector |
Health Red Flags
🚩 Declining cash balances — Burning through reserves
🚩 Rising debt levels — Borrowing to survive
🚩 Negative working capital — Can't pay near-term bills
🚩 Interest coverage below 2 — Struggling with debt payments
🚩 Covenant violations — Breaking loan agreements
🚩 Auditor concerns — "Going concern" warnings
Health Traps
- Ignoring balance sheet because income statement looks good
- Assuming profitable companies are financially healthy
- Not checking debt maturities (when debt comes due)
- Comparing health metrics across different industries
Why Health Matters for Investors
Survival
Unhealthy companies can fail, wiping out your investment.
Flexibility
Healthy companies can invest in growth, buy back stock, or acquire competitors.
Resilience
When recessions hit, healthy companies survive and gain market share.
Lower Risk
Financial health reduces the chance of permanent capital loss.
Next up: How ShareValue.ai calculates Growth and Health Scores.