Understanding: The Financial Health Section

Topics covered in this article:

• Overview: The Financial Health Section
• Analysis for Non-Financial Institutions
  • Financial Position Analysis
    • Terminologies used in this section and their description
  • Debt to Equity History and Analysis
  • Cash Runway Analysis
  • Balance Sheet and various Financial Terminologies
• Analysis for Financial Institutions

Overview: The Financial Health Section

The Financial Health section focuses on examining the company's balance sheet to analyze its financial position and liquidity. We have separate metrics and analyses done on companies broadly categorized as (1) Non-financial Institutions and (2) Financial Institutions.

Analysis for Non-financial Institutions

Key Information:

Debt-to-Equity Ratio

This ratio shows the proportion of money a company borrows compared to the money invested by shareholders. It helps assess the financial risk of the company. To calculate it, divide the amount of debt by the amount of equity.

Debt

It consists of short-term and long-term borrowings such as bonds or loans. Therefore, Debt is calculated as follows:

Debt = Short-Term Borrowings + Current Portion of Long-Term Debt + Long-Term Debt

Interest Coverage Ratio

This ratio indicates how well a company can cover its interest payments using its operating income. A higher interest coverage ratio means there is a lower risk of default. It is calculated by dividing Operating Income (EBIT) by Net Interest Expense.

Interest Coverage Ratio = Operating Income (EBIT) / Net Interest Expense

Financial Position Analysis

This section provides an overview of the Financial Position of a company, categorizing assets and liabilities into short-term and long-term classifications. Below, it shows the company's ability to cover short-term and long-term liabilities, gauging overall financial stability.

Short-Term Liabilities check

This check measures whether, on a short-term basis (within 12 months), the company has a net positive financial position. In the event of financial stress, this check indicates whether the company could liquidate short-term assets to meet its short-term liabilities.

For MSFT, the fact that its short-term assets ($184.3B) exceed its short-term liabilities ($104.1B) indicates a strong liquidity position in the short term.

Long-Term Liabilities check

This check measures whether the company holds short-term assets that are greater than its long-term (12 months) liabilities. In the event of financial stress, this check indicates whether the company could realize short-term assets to meet its long-term liabilities.

The statement that MSFT's short-term assets ($184.3B) exceed its long-term liabilities ($101.6B) implies that the company has enough short-term assets to cover its long-term obligations. This suggests that MSFT's short-term liquidity can also accommodate its long-term financial commitments, which is positive for the company's financial stability.

Terminologies used in this section and their description

Short-Term Assets

Assets expected to be converted into cash or used up within one year or the operating cycle.

Short-Term Liabilities

Financial obligations expected to be settled within one year or the operating cycle.

Long-Term Assets

Assets held for more than one year that are not expected to be converted into cash or consumed within the normal operating cycle or one year.

Long-Term Liabilities

Financial bligations or debts due for repayment over a period exceeding one year.

Debt to Equity History and Analysis

This section focuses on evaluating the financial soundness of a company through various debt-related metrics providing insights into the company's debt management and financial resilience. We check 4 metrics here that contribute to the snowflake score.

Using the screenshot above for Microsoft Corporation's Debt to Equity History and Analysis, the checks done are as follows:

Debt Level Check

MSFT has more cash on hand ($111.26B) than its total debt ($47.24B), indicating a favorable financial position.

Reducing Debt Check

The Debt to Equity ratio for the current year is compared to the debt to equity ratio 5 years ago.

MSFT's debt-to-equity ratio has decreased from 92.2%% to 22.9% over the past 5 years, showing a reduction in reliance on debt financing.

Debt Coverage Check

This check indicates whether, in the event of financial stress, the company is able to meet its debt obligations using purely its cash flow for the year from its operational activities.

Debt held by the company is compared to Operating Cash Flows.

MSFT's operating cash flow ($87.58B) is 185.4% of its total debt ($47.24B), indicating a strong ability to cover its debt obligations.

Interest Coverage Check

This check indicates whether the company's interest obligations are met through earnings before interest and tax (EBIT). A ratio of 5 times earnings indicates a strong level of coverage.

MSFT earns more interest than it pays, demonstrating a comfortable margin to meet its interest expenses and indicating a strong financial position.

Cash Runway Analysis

For companies that have on average been loss-making in the past we replace the debt and interest coverage check with cash runway analysis.

The Debt Level and Reducing Debt checks (checks #3 and #4 in the Debt to Equity History and Analysis) are replaced with the following checks:

Stable Cash Runaway check

This check indicates whether the company’s cash and other liquid asset levels are high enough to cover its negative free cash flow over the next year, should the rate remain stable. If coverage is sufficient, the stock is scored one point.

At the time of this article, since MSFT as a sample from the previous section is not a loss-making company, we will be using Check-Cap Ltd. (NasdaqCM:CHEK) as an example.

CHEK has a strong cash position, providing over a year's worth of runway based on its current free cash flow.

Forecast Cash Runaway check

This check indicates whether the company’s cash and other liquid asset levels are high enough to cover its negative free cash flow over the next year, should the rate grow or shrink at the same rate annually as it had in the past three years. If coverage is sufficient, the stock is scored one point.

Assuming a historical free cash flow reduction rate of 14.8% annually, CHEK's cash runway extends to approximately 1.6 years.

Balance Sheet and Other Financial Terminologies

The Balance Sheet shows the key components of a company's financial position. No specific analysis checks are done in the Balance Sheet chart, it does not have a direct attribution to the snowflake as it's purposely for visualisation only - offering a comprehensive understanding of the company's financial standing and the distribution of its resources and obligations.

Throughout this section, we will be using Microsoft Corporation as a sample. We will use their SEC Form 10K for the fiscal year ended June 30, 2023 as a reference to show how data are derived and presented on the Simply Wall St platform.

Receivables

Owed to the company by customers for goods or services provided on credit.

Inventory

Goods held by the company for sale or production.

Cash & Short-Term Investments

Funds and easily convertible assets held by the company for immediate use or investment.

Physical Assets

Tangible assets owned by the company, such as land, buildings, and equipment.

Long-Term & Other Assets

Miscellaneous (including other current assets) and non-current assets held by the company, including long-term investments and intangible assets.

Accounts Payable

Amounts owed by the company to suppliers or creditors for goods or services received on credit.

Debt

Specific to borrowed funds or financial obligations owed by the company to lenders or bondholders.

Other Liabilities

Various obligations and liabilities of the company that are not classified under specific categories.

Equity

The residual interest in the company's assets after deducting liabilities, representing the owners' or shareholders' stake in the business.

Analysis for Financial Institutions

Financial Institutions (Banks, Financial Service companies, REITs, and Insurance firms) by their nature borrow the majority of their funding (or liabilities), and as a result, conventional measures of debt levels are not generally applicable. For that reason, the SWS app uses a separate series of Health checks specifically applicable to Financial Institutions. The changes are mainly reflected in the Key Information and analysis section specific to Financial Institution.

Simply Wall St systematically examines various aspects of a financial institution's health and risk management, providing valuable insights into the financial institution's leverage, risk coverage, funding stability, lending practices, and asset quality.

Asset Level check

This check indicates whether the Leverage (Assets to Equity) is within an acceptable range of 20 times or less.

Allowance for Bad Loans check

This check assesses the coverage of bad loans, ensuring that it exceeds 100%.

Low Risk Liabilities check

This check examines the proportion of lower-risk deposits compared to total funding (Deposits to Liabilities).

Loan Level check

Evaluates the proportion of higher-risk assets compared to total assets (Loans to Assets).

Low Risk Deposits check

Measures the total loans compared to deposit funding (Loans to Deposits).

Level of Bad Loans check

This check analyzes the level of bad loans (Net Charge Off Ratio).

Financial Institutions' Health Key Information Overview

Throughout this section, we will be using Commonwealth Bank of Australia as a sample. We will use their annual report for the fiscal year ended June 30, 2023 as a reference to show how data are derived and presented on the Simply Wall St platform.

Asset to Equity Ratio

Represents how much a company’s operations are funded by debt versus equity. A higher ratio indicates greater debt financing and increased risk if revenues decline. To calculate this ratio simply divide the total asset by total equity.

Asset to Equity Ratio = Total Assets / Total Equity

For Commonwealth Bank of Australia (ASX:CBA), the total assets amount to AU$1,252B, and the total equity is AU$72B. When you perform the calculations, you'll find that the asset-to-equity ratio stands at 17.4x. This ratio indicates that for every AU$1 in equity, there are AU$17.4 in assets.

Net Interest Margin

represents the difference between interest income earned and interest expenses paid by a bank. A higher margin implies efficient use of investments. This ratio is calculated by dividing the net interest income by the average earning assets.

Net Income Margin = (Interest Income - Interest Expense) / Average Earning Assets

CBA has a net interest margin of 2.1%. To arrive at this figure, we first get the net interest income from the Income Statement.

From the balance sheet, we get the average value of assets that generate interest income. It typically includes loans, investments, and other interest-earning assets.

Then, we calculate its average earning assets using the 2022 and 2023 figures. In CBA’s case, the average earning assets is AU$1,091B. Now that the net interest income and average earnings interest are available, simply divide the net interest income (AU$23.06B) by the average earning assets AU$1,091B.

Net Interest Margin = AU$23.06B / AU$1,091B = 0.021 or 2.1%

This means that for every AU$100 in assets, CBA holds, it's earning $2.10 in profit from the interest it charges on loans and investments after deducting the interest it pays to depositors and lenders.

Total Deposits

The total amount of money that customers have deposited in a bank. This represents a liability and a source of funds for lending and investing.

Loan to Deposits Ratio

Measures a bank’s liquidity by comparing its total loans to its total deposits. If the ratio is too high, the bank might not have enough liquidity to cover unforeseen funding requirements. It is calculated as follows:

Loan to Deposits Ratio = Loans / Deposits

Therefore,

Loan to Deposits Ratio = AU$931.87B / AU$864.49B = 1.07 or 107%

CBA's Loan to Deposits Ratio slightly exceeds 100%, their 107% ratio maintains a balanced approach, reducing liquidity risks hence labeled as “appropriate”. Striking this balance is crucial, as excessively high ratios can endanger financial stability.

Bad Loans

loan amounts that are unlikely to be repaid by the debtor and are considered uncollectible, leading to higher loan loss provisions and lower bank profits. Bad loans (%) are calculated as follows:

Bad Loans (%) = Non-Performing Loans / Loans

Therefore,

Bad Loans (%) = AU$7.48B / AU$931.87B = 0.0080 or 0.8%

Allowance for bad loans

a reserve to account for possible future losses from loans. A high allowance ratio (at least 100%) means the bank can withstand future losses better.

Allowance for Bad Loans (%) = Loan Loss Reserve / Non-Performing Loans

Therefore,

Allowance for Bad Loans (%) = AU$5,791B / AU$7,437B = 0.7787 or 78%

This means that CBA has set aside an allowance for bad loans that is equivalent to 78% of its non-performing loans which is considered low as it won’t be able to cover potential future losses from bad loans.

Current Ratio

Measures a company’s ability to meet short-term obligations, where a higher ratio indicates a stronger ability to pay off short-term debt. Calculated by dividing current assets by current liabilities where a value above 1 is considered good.

Current Ratio = Current Assets / Current Liabilities

Therefore,

Current Ratio = AU$219.18B / AU$992.43B = 0.22x

A current ratio of 0.22x implies that CBA has $0.22 in current assets for every $1 of current liabilities. This means that the bank may not have enough liquid assets to cover its short-term debts. This could potentially pose a risk if the bank faces unexpected financial challenges or a sudden increase in customer withdrawals.