The price that an investor pays for buying a company’s share is not for its current performance, but always for the future performance of the firm. Obviously, investors look for certain specific tools to assess future financial health. While there is no single tool available, the following four steps can help you assess the future financial health and long-term sustainability of the business.
Assess the goals and strategies
The starting point for assessing a firm’s future health starts with an investigation of the firm’s goals and strategies. Investors should assess and understand management’s goals for the firm and each of the product lines in which it chooses to compete. The goals should match with the company’s strategy for each product line. Apart from the above, operating characteristics of the company play a major role in the financial health of a company. Assess whether the management uses all the assets efficiently. Generally, investment in technological improvements could increase operational efficiency.
Assess the outlook for sales
The outlook for the market should be properly assessed. The market must have the potential for growth to facilitate an increase in sales and revenue in the future. A market which is already heavily saturated could probably force the company to lower prices and thus reducing profit margins. The market’s volatility and predictability should also be taken into account.
Assess product-market strategy and investment
The third step is assessing the current value of the investments that have been made to support the firm’s product-market strategy. The product-market strategies require investments in various current assets such as accounts receivable, inventories and non-current assets
such as equipment, plant, etc., or even acquisitions. Investors should assess the value of these assets over the next two to three years.
These estimates can be made from analysing the firm’s past performance patterns. Ratios and other indicators derived from current financials and studying the firm’s past include the following items such as collection period, days of inventory, and plant and equipment as a percentage of cost of goods sold and the like. A reasonable value should be applied to the sales and cost of goods while developing an accurate forecast.
Assess future profitability
A company must have a profitable outlook for the future. The magnitude of profitability has a strong influence over several vital financial elements. First, the firm’s access to debt finance is heavily influenced. Second, the value of the firm’s common stock and the willingness to issue is affected. Third, the firm’s sustainable sales growth looms upon the level of profitability. The firm’s past financial performance is an indicator on how the firm will perform in the future.
So, investors should try to find out answers for the following questions such as (a) what is the average level, trend, and volatility of the firm’s profitability (b) whether the current level of profitability is sustainable in the future (c) what effect does competition and regulatory guidelines have on profitability (d) in case market conditions and competition improve, will profitability also improve (d) whether the management has any plan on implementing profit improvement programme and, if yes, what is the plan (e) Is there any inefficiencies such as large inventory build-ups or lower than industry average accounts receivables.
To conclude, as an investor, one should devote a significant amount of time in exploring the corporate financial system which is driven by the company’s goals, strategies, market conditions, operating characteristics and risks. The information relevant to the above aspects could be observed directly from the financial statements and by referring to the management discussion and analysis report which is part of the annual report of most companies.
The writer is professor of finance & accounting, IIM Tiruchirappalli