Financial safety in the context of investing generally refers to items listed in a company’s balance sheet. The balance sheet, also known as the statement of financial position, shows what the company owns (assets) and what it owes (liabilities), as well as the company’s net worth. The minimum for a company to pass is to have its assets more than its liabilities, or in other words, a positive net worth.
1: Total Assets > Total Liabilities
From the 613 listed and traded stocks on the Singapore Exchange (SGX), 522 stocks have fulfilled this criterion. Many companies have passed this check since it is the minimum requirement for the financial safety aspect of a company. Upon closer analysis, the difference between total assets and total liabilities is referred to as the book value of a company. Strictly and solely from a financial safety perspective, the higher the price paid (share price) for a stock relative to its book value, the lower the financial safety. This is because, assuming the company were to liquidate at this very moment, investors who paid less compared to the company’s net worth would have positive returns on their investment.
2: Price to Book < 1
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From the 522 listed and traded stocks on SGX, 264 companies have fulfilled this criterion. However, investors should take caution because the assets may be subjectively valued. An example of this is the use of historical cost accounting versus fair value accounting when valuing property as part of a company’s assets. The most conservative approach to evaluating the book value of the company is to discount every item in the assets section of the balance sheet. This is because, assuming the worst-case scenario happens, which is when a company is too distressed and winds up, the company will likely have to sell its assets at a discounted price (fire-sale price), so the realised value of its total assets could be significantly lower than what is reported. This process is tedious; however, a general rule of thumb is to discount assets that are less liquid compared to liquid assets, as it is relatively harder to convert these assets into cash.
3: Price to Tangible Book < 1
There is also a simpler way of adjusting the book value, which is less tedious. It is only to take the tangible assets when computing the book value of the company. Although this may rule out companies with a high proportion of intangible assets, the investor who invests in companies with excellent financial stability will understand that this is a necessary step. Goodwill, for example, is an intangible asset which is defined as the premium a company pays during an acquisition, attributable to non-quantifiable factors such as brand reputation and customer loyalty. Hence, an investor who seeks and prioritises financial safety should not pay more than the adjusted book, or in this case, tangible book. Out of the 264 stocks that have a P/B ratio of less than 1, 230 companies have a price-to-tangible-book-value ratio of less than 1.
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4: Current Ratio > 1
Next, an important aspect of financial safety to consider is a company’s liquidity. In the context of financial safety, liquidity refers to a company’s ability to fulfil all its short-term financial obligations. In other words, its current assets must be higher than its current liabilities. This is measured by the current ratio, where any value above 1 is good. For an investor who wishes to scrutinise this ratio further, there is the quick ratio, which is a portion of the company’s total current assets, including cash, short-term marketable securities, and accounts receivable, against its current liabilities. A more conservative ratio is the cash ratio, which essentially compares the company’s cash and cash equivalents to its current liabilities. From the 230 companies that have been filtered so far, 193 companies have a current ratio of 1 or more.
5: Net Debt to Shareholders’ Equity < 0.3
Generally, the higher the amount of debt a company has in its capital structure, the greater the risk it poses from a financial safety perspective. This is because interest is owed on the debt, and it is a financial obligation that must be fulfilled. Net debt is the total debt after deducting cash and cash equivalents. Although this ratio is subjective, an acceptable ratio would be 0.3 times, and a conservative ratio would be less than that. Many companies have negative net debt, indicating that they have more than enough cash to cover all their interest-bearing financial obligations. A hundred and thirty-nine companies from the list of 193 have a net debt-to-equity ratio of 0.5 times or less.
6: Interest coverage ratio > 2
From the 139 stocks, 63 companies fulfil the criterion of having an interest coverage ratio of over two times. For companies with net debt, they must generate sufficient profits to cover their interest payments, thereby preventing them from becoming financially distressed. The profits are typically measured by ebit (earnings before interest and taxes), which must be at least twice its interest expense over a period for it to have good financial safety. Although this may not be entirely applicable to companies that have more than enough cash to cover all their debt, having a strong interest coverage ratio is a good indication that a company’s financial safety is in check.
7: Altman Z-Score > 3
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The next element in assessing financial safety is the Altman Z-score of a company, where 23 stocks out of the previous 63 companies have met the criteria. The Altman Z-score measures the company’s financial risk and safety, particularly in areas such as financial distress, insolvency, and bankruptcy. The components of this formula include the revenue, ebit, total assets, total liabilities, working capital, retained earnings, and the market value of equity.
Using these seven points, investors can filter and select companies that have, at a minimum, acceptable financial stability, all the way to excellent financial health. The tables above display the SGX-listed companies that demonstrate good financial safety, categorised as follows: Table 1 for stocks with a market capitalisation exceeding $100 million and Table 2 for those with a market capitalisation below $100 million.
Depending on the risk appetite and capacity of individuals, investors can vary the values of the previously mentioned points; however, having a minimum acceptable level of financial safety is necessary when calculating overall risk. The next part of this series will cover what to look for when studying the profitability aspect of investing.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation or solicitation, or expression of views to influence readers to buy or sell stocks, including the stocks mentioned herein. Any personal investments should be made at the investor’s own discretion and/or after consulting licensed investment professionals, at their own risk. The author of this article does NOT hold or own any stock(s) featured in this article or have a vested interest in it at the time of writing
