Before investing in any company, you need to conduct a financial health check.
In this article, Lincoln Indicators discusses:
- How running a financial health check over your ASX share portfolio is an essential part of disciplined portfolio management and due diligence.
- The role of fundamental analysis in the financial health due diligence process.
- Why financial statements are the key to understanding a company’s financial health.
We all know that, when it comes to ourselves, being in good health should really be our number one priority. If we’re in poor health, it’s important to take steps to rectify the situation as we’re putting ourselves at risk. Then we need to have regular health checks so we can stay in tip-top shape.
It’s the same with the financial health of your share market portfolio. To achieve your long-term financial objectives, and to stay in tip-top financial shape, it’s prudent to conduct regular financial health checks on your shares. If any of the companies in your portfolio are sick, they will drag down your total portfolio and jeopardise your overall financial health.An essential part of disciplined portfolio management
As an ASX investor you are a part owner in a company and therefore you should be doing your due diligence before investing. Without knowing the true financial health of a company you are effectively gambling with your money, and seriously risking loss.
Even the world’s most successful share market investors, including Berkshire Hathaway’s Warren Buffett, need a framework to invest. To this end, they often use fundamental analysis to assess a company’s balance sheet, its profit & loss statement and cash flow.
The first step in fundamental analysis
As an integral part of our fundamental analysis methodology, Financial Health is Lincoln Indicator’s first and most important golden rule and should be the foundation of all investment decisions when it comes to investing on the share market. It is really the cornerstone of investing successfully on the share market, with control, confidence and peace of mind relative to your investment objectives.
Developed in 1982 by Lincoln founder, academic and former Olympian Dr. Merv Lincoln, Lincoln’s unique Financial Health model assesses key accounting ratios relating to each ASX company’s profitability, cash flow, liabilities and assets. It then determines a Financial Health rating commensurate with the business risk of the company, so investors can quickly identify stocks that warrant further consideration and eliminate those that don’t.
To be considered worthy of investment, a stock must exhibit Strong or Satisfactory Financial Health ratings and must be healthy for at least two consecutive periods. It is not sufficient for a stock to be healthy for solely one period. Just like going to the gym, consistency is the key to establishing a healthy platform.
Conducting a financial health check
As any general medical practitioner will attest, there are many factors that come into play when assessing the physical health of a patient. Sometimes, general symptoms mean nothing at all in the overall scheme of things. At other times, an accurate diagnosis can only really be made by conducting more detail tests.
A Financial Health check is fundamentally the same. A fall in a company’s share price may signal that there are serious problems afoot, or the fall could simply reflect general market movements. If a company is fundamentally sound, and has demonstrated strong characteristics over time, there’s probably nothing to really worry about in a longer-term context. Its price fall could actually present a buying opportunity. Quality companies will always deliver good returns over time.
Yet, the only way to really know the underlying financial health of a company is to check its pulse rate and run its numbers through a series of rigid accounting tests.
What should you be looking for?
Checking under a company’s financial bonnet will tell us all sorts of things. You don’t have to be a qualified financial mechanic either, and fortunately our powerful Stock Doctor platform makes the whole job of financial analysis and assessment easy and very transparent.
There are several key areas to assess when you examine a financial report. Fundamentally, your objective is to gain an understanding of a company’s Financial Health and performance. Indicators include profitability, a strong balance sheet, manageable debt levels and positive cash flows. You can identify important information within a company’s financial accounts, and it’s best to start with the profit & loss statement, the balance sheet and the cash flow statement.
Profit & Loss statement
Important areas to check within a company’s P&L statement are the extent of funding sourced from retained profits (lower risk companies have a higher proportion of their funds being sourced from retained profits), and the level of profit that can be used to meet short-term commitments (lower risk companies have a higher margin of safety to meet short-term commitments from cash flow generated from trading operations).
Strong balance sheet
A company’s gearing level (total debt-to-equity) determines whether a company has manageable debts and can meet its ongoing repayment obligations. A high gearing ratio warns investors that a company’s Financial Health may be vulnerable to a deterioration in its business conditions.
It’s also important to focus on a company’s cash balance to total liabilities (lower risk firms have more cash that can be used to pay for commitments).
Cash flow statement
In the same way that our own income needs to be able to meet our living expenses, a company’s cash flow must be enough to cover its interest payments and short-term debt. Look for strong operating cash flow to determine how well a company is generating cash from its core business activities.
In conclusion As an ASX investor you are a part owner in a company and therefore you should be doing your due diligence before investing. This allows you to make informed and confident investment decisions. Without knowing the true financial health of a company you are effectively speculating, and seriously risking loss.
Examining a company’s fundamentals must always come first and all the numbers must add up.
Our team is always here to help. If you would like to discuss this article in more detail or would like more information on Stock Doctor or our Managed Investment Solutions, please contact us on 1300 676 333.