What Makes a Company Financially Healthy?

Think of a tree. What you notice is the trunk and the leaves. What decides whether it survives a storm is underneath: the roots. A company's balance sheet is its root system — rarely exciting, but it's what holds everything up when the weather turns.

Three things to check

1. Cash

Money in the bank, or in investments the company could sell quickly. Cash is a cushion: it pays the bills in a bad year without having to borrow on bad terms.

2. Debt

Money the company has borrowed and must pay back, with interest. Debt isn't automatically bad — plenty of solid companies borrow sensibly. The question is how much, compared with what the company earns.

A useful rule of thumb: roughly how many years of earnings would it take to pay off the debt? A year or two is generally comfortable. Five or more is a heavy load.

3. Bills due soon

Does the company have enough short-term money to cover what it owes in the next year? If not, it may need to borrow or raise money — and that's hardest exactly when things are going badly.

An example: two companies, same sales

Company A has $400k in cash and $100k of debt. Company B has $50k in cash and $600k of debt. In a good year you might not notice the difference. In a bad year, Company A can keep going and even invest; Company B may be forced to cut back, sell assets or borrow at a high price.

One exception: banks and insurers

For banks and insurance companies, borrowing and lending is the business, so the usual debt measures don't apply. Sixth Element says so rather than giving them a misleading score.