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1/10/2003
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Taking Stock: Check Financial Pulse Of Your Partners

Size gives us assurance the company isn't a fly-by-night operation.

Is your business partner about to go out of business? There's nothing more frustrating than having to rely on a partner that's about to file for bankruptcy. New, small companies often provide innovative products that larger, established concerns ignore. The advantages of being small only seemed to increase as the '90s wore on. This wonderful state of affairs lasted until the tech bubble burst in early 2000. In an economic downturn, there's great value in being big and having adequate financial resources. Avoiding the unpleasant situation of your partner going bankrupt is especially important in these times, so let's look at how you can assess a business partner's financial health.

We intuitively associate big with financially solid, which holds true most of the time. The quick check here is to look at the amount of assets (buildings, plant, equipment, cash, inventory, etc.) minus goodwill on the balance sheet. Size gives us assurance that the company isn't a fly-by- night operation and might be able to off-load some buildings or a plant if hard times hit. Large also implies that other people have done business with this particular vendor. A small company might have only a couple of customers, putting it at risk if one of them decides to pull out.

Profitability is always a good measure of how well a company is doing. This includes measures such as net income, operating income, and gross profit. Trends in related ratios (net margin, operating margin, and gross margin) also are important. Is the company prospering or are its margins deteriorating?

Size doesn't always keep you out of financial straits, as the problems of Kmart, Lucent Technologies, and United Airlines show. The veil of accounting often hides an underlying problem in cash generation. Net income might be rising, but somehow cash flow isn't keeping up. A quick look at the cash-flow statement will reveal how much (or how little) cash the company is generating from operations. This should be compared with net income and, if there's a large discrepancy, you must figure out why. If a company is burning cash from operations, compare this with the cash and equivalents on the balance sheet to understand how many quarters the company will be able to stay in business before it must raise more cash by issuing stocks or selling part of the business. Raising money when a company is already financially strapped can be very difficult, though.

Inventory build-up and the inability to collect accounts receivable from customers are two possible signs of a cash-generation problem. If inventories are increasing at a faster pace than sales for several quarters, it might indicate a company can't sell the expected amount of goods because its products are uncompetitive or its customer base is weak. If accounts receivable are increasing significantly faster than sales, this could indicate problems collecting money from customers or that the company believes that it has to extend credit to make sales -- a temporary, but not a long-term solution.

Financial health is one facet of assessing a company. Other equally important measures include the competitive landscape, industry dynamics, competitiveness of products, customer service, responsiveness to customer needs, and long-term vision. However, in a capitalist society, no matter how visionary a company is, it must generate profits and cash to stay in business.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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