Course 202: Analyzing a Company
Third Quality Check: Financial Health
In this course
1 Introduction
2 First Quality Check: Growth
3 Second Quality Check: Profitability
4 Third Quality Check: Financial Health
5 Fourth Quality Check: Valuation
6 Put Them through the Wringer

Is paying off credit-card debt a high priority for you each month? If the answer is yes, you probably want the companies you own to be burdened with as little debt as possible, too. That way, you can be sure they'll still be around after the next recession. When times are good, a company can plump up its ROE with debt leverage. That way, it generates a higher ROE, but at the (sometimes hidden) cost of greater risk. That's why it is preferable for companies to sport conservative financial-leverage ratios. Clothing retailer Abercrombie & Fitch ANF generates returns on equity of more than 50% and does so with very little debt leverage. Its financial-leverage ratio is a sparkling 1.7, meaning that for every $1.70 in assets on its balance sheet, it has $1 in shareholder equity backing it up. Abercrombie boasts that other characteristic of a financially sound company: positive free cash flow, or the amount of cash a company generates after capital spending. A company can either redistribute this cash to shareholders (through dividends or share repurchases) or use it to fund growth opportunities. Free cash flow is therefore a proxy for how much wealth a company is generating for its owners.

Next: Fourth Quality Check: Valuation >>


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