When times are good, a company’s financial situation tends to slip into the background. Cash flow is healthy; bank loans are available; and, if necessary, stock and debt offerings can be made to bring in funds for expansion. However, the picture turns quite a bit darker when the economy starts contracting. During a recession, cash flow falls, banks aren’t eager to lend, and pricing conditions are tougher when trying to sell shares or corporate debt. It’s during the hard times that a company’s financial strength shines through. The recent financial crisis brought that home with a vengeance.
The importance to investors of a company’s financial strength matters in several ways. When income is the primary consideration, a strong balance sheet provides greater assurance that a dividend can be maintained. Adequate financing is also important for stockholders to ensure that operations can be expanded without an undue portion of the benefit going to the bank or to bondholders. Shares of deep-pocketed companies are generally more stable, as well.
Value Line classifies 1,700 companies’ Financial Strength ratings (located at the bottom right of every Ratings & Reports page) from A++ to C, in nine steps. Those receiving the top grade include household names, such as Coca-Cola (KO - Free Analyst Report), Exxon Mobil (XOM - Free Analyst Report), Intel (INTC - Free Analyst Report), IBM (IBM - Free Analyst Report), Johnson & Johnson (JNJ - Free Analyst Report), McDonald’s (MCD - Free Analyst Report), and Wal-Mart Stores (WMT - Free Analyst Report), among others. The lowest grade is reserved for companies experiencing serious financial difficulty – even insolvency.
Quite a few ingredients go into Value Line’s Financial Strength ratings. Balance sheet leverage, business risk, the level and direction of profits, cash flow, earned returns, cash, corporate size, and stock price, all contribute to a company’s relative position on the scale. The amount of cash on hand, net of debt, is an important consideration. Take Microsoft (MSFT - Free Analyst Report), another A++ rated company, for example. With over $57 billion in cash available, the software giant can easily finance its operations, capital spending, dividend obligations, and a share repurchase program. At the other end of the spectrum, struggling retailer Zale Corp. (ZLC), rated C+ for Financial Strength, is less well financed.
Muddying the waters is the fact that not all industries are structured the same way financially. The Utilities and Financial sectors are prominent examples in that regard. Electric, natural gas, and water utilities are much more highly leveraged than industrial companies, with debt often topping 50% of total capitalization. Utilities are required to use more debt, because it is cheaper than equity. The increased financial risk is offset by reduced business risk, since utilities are a regulated monopoly. Relatively more equity and better fixed-charge coverage ratios support utilities’ Financial Strength ratings. Con Edison (ED) is an example of an electric utility with above-average finances.
For financial services providers, such as banks, thrifts, and insurance companies, the amount of capital, as measured by the equity to assets ratio, is a key consideration. More capital is better from a regulatory standpoint, but too much cuts down on profitability. Loss reserves are important, as well, as are funding sources. For lenders, deposits insured by the U.S. government represent a firmer source of liquidity than borrowings. It’s when liquidity dries up that disruption occurs in the credit markets.
It’s important to note that financial strength doesn’t always translate into stock market outperformance. Shares of smaller companies and companies that are more leveraged often do significantly better when the economy is coming out of a recession. Since those groups are more sensitive to broader business conditions, their profits stand to rise more on a percentage basis in the early stages of a recovery. But, for investors looking for dividend-paying stocks and stocks to hold on to for a long period of time, it pays to be aware of a company’s financial standing.