Enhance Your Stock Selection with Financial Health Analysis

Let's examine key financial scores to help you determine whether you're holding onto a strong company/stock or if it might be time to consider selling and exploring other options within the same industry. Financial score analysis provides a quick and efficient way to evaluate a company's financial health without the need for extensive manual analysis of financial statements.

For this analysis, we'll use the Financial Modeling Prep Financial Score API to get a summary of your chosen stock's financial scores. This tool is invaluable for developers looking to integrate financial data into their applications, as well as for investment analysts and traders who want to improve their stock analysis process. Here's a detailed look at what these scores mean and how to apply them.

Understanding vital financial scores

Altman Z-Score. This score predicts the likelihood of a company going bankrupt. It is calculated using profitability, leverage, liquidity, and capital efficiency metrics. The formula for Altman Z-Score is:

1.2*(working capital / total assets) + 1.4*(retained earnings / total assets) + 3.3*(earnings before interest and tax / total assets) + 0.6*(market value of equity / total liabilities) + 1.0*(sales / total assets).

For instance, it assesses how much profit a company makes relative to its assets and whether it can cover its debts without liquidating assets. A low Z-Score for a company like Ford (F) might indicate financial distress due to insufficient profits from sales to cover debts. Investors can use the Altman Z-Score to assess the risk of corporate bankruptcy. A score below 1.8 suggests a high probability of bankruptcy, whereas scores above 3 indicate a low likelihood of financial failure.

Piotroski Score. This score evaluates financial performance through nine binary tests. Each test checks aspects like profitability, cash flow, and financial leverage. In simple terms, it assigns points if certain criteria are met. Example:

Positive net income (1 point). Positive return on assets (ROA) in the current year (1 point). Positive operating cash flow in the current year (1 point). Cash flow from operations being greater than net income (quality of earnings) (1 point). Lower amount of long-term debt in the current period compared to the previous year (decreased leverage) (1 point). Higher current ratio this year compared to the previous year (more liquidity) (1 point). No new shares were issued in the last year (lack of dilution) (1 point). A higher gross margin compared to the previous year (1 point). A higher asset turnover ratio compared to the previous year (1 point).

Apple (AAPL) scoring an 8 out of 9 means it's performing well in most areas. A high Piotroski Score for Netflix (NFLX) suggests not only profitability but also improvements in managing debt and cash flow.

Working Capital. Measures short-term financial health by subtracting current liabilities from current assets. A positive number indicates the company can easily meet its short-term obligations. Amazon's (AMZN) positive working capital means they have sufficient cash to cover immediate debts without selling inventory.

Retained Earnings. This is the profit a company has left after paying taxes, dividends, and covering both direct and indirect costs. Investors and traders can examine the retained earnings to see if the company has money remaining after all expenses. They can also compare this number to those of companies in the same peer group.

Market Capitalization. This is another important number for investors. It is calculated by multiplying the stock's market price by the number of shares outstanding. A large market cap can indicate that the stock is less volatile compared to smaller-cap stocks. This is because larger market caps tend to attract bigger institutional investors, who place large volumes of bids and asks, making the stock more stable.

EBIT (Earnings Before Interest and Taxes). This figure shows operational profitability before tax and interest expenses. Calculated by subtracting operating expenses from revenue, excluding taxes and interest. High EBIT for Boeing (BA) indicates strong profitability from aircraft sales before accounting for taxes and loan interest.

Applying These Metrics in Investment Strategies.

Now, let's see how traders can apply these valuable financial metrics in their trading strategies to ensure they are dealing with great shares.

For Long-Term Investors. Focus on the Altman Z-Score and Piotroski Score. High scores suggest a financially robust company, ideal for long-term holding.

For Value Investors. Use the Piotroski Score to identify undervalued stocks. A company with a strong score but a low stock price could be a bargain. Also, retained earnings can serve as a good indication of a company's efficiency, but they need to be compared to its closest peers.

For Short-Term Traders. Monitor working capital and react to earnings announcements. Positive earnings news can lead to quick stock price increases. Also, sorting companies based on market cap will help traders identify less volatile stocks that are highly popular among larger players.

Understanding the mentioned financial metrics can significantly aid in deciding whether your selected company is a worthy investment. However, remember these scores are just one part of a broader analysis. Always consider other factors like market trends, company news, and economic conditions before making investment decisions. This approach ensures you're not only looking at numbers but also understanding the broader context in which these numbers exist.