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WHAT DETERMINES GOOD FINANCIAL HEALTH?
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published-Thu 01 Dec 2005

 

WHAT DETERMINES GOOD FINANCIAL HEALTH?

BY: SHEPHERD SHAMBIRA

The state of different companies and organizations is normally depended on the organisation’s financial status. The balance sheet is a statement which shows the state of affairs as at a given point in time. The profit and loss account is a description of the financial performance of a company over a given period of time. It is interesting to note that whether an organization is a profit making enterprise or a non profit making entity, it is possible to evaluate its financial status at any point in time. When one is considering acquiring shares in a quoted company the idea is that one will be expecting to earn something on that investment so that their original seed grows into a harvest of wealth. Assuming that an investor is rational, one would not want to invest in a company which will collapse soon after or in the foreseeable future. The challenge to investors is therefore to avoid placing capital in a business that is set to fail.

The literature on corporate failure prediction models covers a number of areas from statistical analysis to other non-numeric assessments. However, the ordinary investor may not always be in a position to do the complicated statistical calculations using the Z-Score (logistic regression analysis) and discriminant analysis or other methods. The initiated are likely to advocate for standard ratio analysis and use of the published accounts in determining the financial health of a company. Ratio analysis is usually very useful when the ratios are compared between companies in the same industry and where possible on an international basis. The other approach is to analyse the trend in accounting ratios for a given company and compare this to its peers in the same industry. There are usually three broad categories in ratio analysis which investors must be aware of.

The liquidity ratios give insight into the liquidity position of a company. This measures for example, the ratio of cash sales to total sales. The principle is that it is preferred to have as much cash as possible since cash gives flexibility in business. You can not easily convert your stock of goods or debtors into cash if you have an immediate opportunity which requires you to make a cash outlay. However, if you have a huge cash reserve you can easily make the decision and act by signing the required cheque. A good example, of an opportunity is a financially distressed competitor who may not have sufficient liquidity to survive the harsh economic conditions. Taking over such a business may present some strategic advantages. The second category of ratios takes a look at profitability. For example, what percentage of sales is our gross profit? What is the percentage of operating expenses to total revenue? Comparing such ratios between companies and over time helps to indicate the level of profitability in a given industry. Where a company is facing declining margins, it may be indicative of stiff competition and failure to adapt to changing economic conditions. Furthermore, increased competition may point to the need for a company to reconsider their business model and even whether they should be in business at all!  The third key category of ratios evaluates the structure of capital funding the business. The accounting equation states that the total assets of a business are given by the sum of its liabilities and owners capital. (Assets equals Capital plus Liabilities). The key question here is the extend to which a company is funded by debt. The view held by most analysts is that increasing the levels of debt increases the level of financing risk to the company which is not present in a wholly equity financed company. For example, the creditors are outsiders whose interests are not always the same as those of the owners of the business who hold the company’s common stock. Therefore, the analysis of these various ratios will initiate a more focused investigation which should clearly highlight the financial status of the business.

The picture highlighted by accounting ratios will for example cause an investigation into the efficacy of management. For example, where certain poor performance points to bad management decisions rather than variables over which a good manager would be successful. Specific examples may include an unreasonably high cost base compared to other players in the same industry. The funding of a business using expensive debt after paying out capital through a cash dividend instead of deferring the dividend declaration or declaring a non-cash dividend. It is interesting to note that there are some companies which may declare what may appear to be a very attractive profit figure even though their cash flow position may be pathetic. The risk with such companies is liquidity and if creditors are not managed properly the risk of failure may be high.

When we discuss corporate failure we are referring to the closure of a company due to a number of reasons. Failure may also result in a company being taken over aggressively by competitors. While mergers and the idea of being taken over are not always negative, it is important to note that the victims of a hostile takeover are unlikely to get a fair value for their investment. A failing company can also enter into a legal composition; liquidation or seek to be absorbed by a stronger company and so on. The game of investment management is about information. Historic information about the company and future information that can be deduced from known facts. The perceived health of a company is therefore depended upon the evaluation and interpretation of this information.

 

 

 

This article is published for general investment advice and it must be noted that the price of
equities and the income derived from them can rise as well as fall. Neither First Mutual Limited nor the author shall be held liable for any losses as a result of the investment advice
contained in this article. It is important that specific investment advice is sought as each
investor’s investment will be dependent on their circumstances.

Contact:
Rashid Mudala: 091 276 226
Shepherd Shambira :091 252 639
First Mutual Limited Head Office: (263) (04)886000/34
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