Financial strength evaluation

In order to evaluate a company's financial strength, you fist need to figure out the debt level: is it low or high? Well, there's a ratio for it: total liabilities to shareholder's equity (equity in short, which is the total assets minus the total liabilities). If the TL/E is less than 0.5, the company is doing great as it has low debt. If the TL/E is 0.5 or higher, the company is a high-debtor and its finances should be looked at carefully considering the financial strength test for high-debt companies.

So now, we can focus on low-debt companies. You need to look at the operating cash flow and the working capital to evaluate the company's financial fitness. The working capital is the current assets (cash, inventories and accounts receivable) minus the current liabilities (accounts payable and short-term debt). Ideally, you want both of them to be positive. If the cash flow is positive and the working capital is negative, you have to make sure the operating cash flow exceeds the working capital deficit. If the cash flow is negative and the working capital is positive, you need to compute the monthly cash burn rate by dividing the operating cash flow by 12 and then see how many months the working capital can sustain the cash burn rate (divide the working capital by the burn rate). If there's enough cash to last two years, then the company might be ok.

All in all and as far as low-debt is concerned, it may a good idea to stick with companies that have positive operating cash flow and positive working capital. You don't have to of course.

Let's look at an example to hopefully clarify all this!


Cash flow and balance sheet for Panera Bread Company, Inc. PNRA obtained at morningstar by following the "quotes", "financial statements" and "5-yr restated" links.

The total liabilities equals Current Liabilities (118.0) plus Long-Term Liabilities (76.8), that is, 194.8. The shareholders' equity is 439.2. This gives a TL/E ratio of 0.44. Oh boy, we have uncovered a low-debt company! Let's look at operating cash flow and working capital to check if the company is financially sound.

The operating cash flow is 170 (always look at the trailing twelve-month TTM figure). The working capital is the sum of Cash (22.0) and Other Current Assets (62.0) minus Current Liabilities (118.0), that is, -34.0. We have positive operating cash flow but negative working capital. Because the TTM operating cash flow is (much) greater than the working capital deficit, Panera Bread passes the financial strength test for low-debt companies (not with flying colors though).