Evaluating

1. Is the company in, or approaching, financial difficulty? Most companies are not in financial distress, but it makes sense to check for this possibility immediately as a way to eliminate at least one end of the spectrum. Firms in financial difficulty display several of the following conditions:

a. Low or negative earnings. Profitability ratios, which are based on net earnings and operating earnings, can reveal difficulties in the firm’s ability to cover its costs.

b. Negative cash flow. Lengthening activity ratios versus the firm’s history and versus its industry, plus changes in the sources-and-uses-of-funds statement, will indicate problems in generating cash internally.

c. High financial leverage, revealed by a high debt-to-equity ratio or a high debt-to-capital ratio and a low EBIT-to-interest ratio relative to the firm’s own history and relative to average ratios for the firm’s industry.

d. Low liquidity, as evidenced by low current ratio, low quick ratio, low cash balance, low turnover of accounts payable, and, generally, difficulty in meeting cash obligations as they come due. Missed dividend or interest payments are strong signals of difficulty.

e. Low stock prices, compared with historical levels and with price-to-earnings ratios of peer companies.

2. If the company is not in financial difficulty, is it financially “fit”? Some companies are healthy in the sense that they survive year after year, but they do not exhibit robustness against the potential challenges of their industry. Those companies often appear in the lower half of their industry peer group in terms of the major categories of financial ratios. Financially fit companies are more profitable, turn their assets faster, are more liquid, and use financial leverage more judiciously than their peers. More importantly, coherence exists between the financial standings and the business strategies of “fit” companies. Management’s statements of goals and policies will seem reasonable in light...