7 Step Evaluation Process

1. Summary: What is the overall financial health of the company? Is it on a downward trend? Is it in the Warning Area?
2. Check for any Notifications above the graph:
   1. Is the company a subsidiary? If possible, look at the parent
   2. Are the accounts late? If so, treat the company as being in the Warning Area Distressed?
   3. Have documents been filed to indicate the company is in distress. This is clearly critical. Is there any other warning that could impact the financial health?
3. Companies in the Warning Area may be vulnerable to financial distress. It is important to note that being in the Warning Area certainly does not mean a company will fail. It means it is exhibiting financial characteristics of companies that previously went on to fail and it is a warning that the company may be vulnerable. 
4. Deteriorating H-Scores: Even if the company is out of the Warning Area, where there is a declining H-Score, check the reasons for the decline (as identified in the Strengths & Weaknesses) 
5. Companies close to the Warning Area: This could indicate that it may only take a marginal negative change to put the company into the Warning Area
6. Erratic profiles: This unusual profile show the financial fortunes fluctuate wildly and it may be difficult to rely on past trends

1. Summary: Has the market detected any problems? Or, is the market perhaps missing the company’s fundamental weakness or strength as identified by the H-Score
2. Equity volatility
   When you see the financial strength of the company diverging from the market perception of the future strength of that company it is always worth further investigation.
   What has the market detected? Is the market simply revaluing a previously over (or under)-valued market cap or is there a more serious issue? Has the market over reacted? Do the financials reflect the concern or is there a critical event that has happened after the financials were issued?
   Tip: Use the financial Experiment facility to test the impact of a change – such as a profit warning.
   
   
3. In cases where a rise in the share price is accompanied by a deteriorating H-Score, this is either:
   1. Because the market has missed the vulnerability
   2. Because the market has given a lot of value to the acquisitions & future expectations of the company

1. Summary: What are the company’s financial strengths and weaknesses?
   Profits?Assets - Liquidity & working capital? Funding structure? Think of the Summary Strengths & Weaknesses as a sign-post directing you where to look (The higher the scores the stronger):
   
   1. 1. 1. The Line graph represents the strength of the profits
         2. The Blue bar represents the strength of the Asset Management (liquidity, working capital)
         3. The Green bar represents how well the assets have been funded (net worth, debt dependency & the reliance on Current Liabilities)
   
   Look out for:

1. 1. Slightly below average, but a nicely balanced profile – means the company is reasonable in the key financial management areas
   2. Weakening sharply - Latest period is weak in all areas No redeeming features 
   3. Weak profits for 3 years but Balance Sheet remains very  strong - 
      A strong Balance Sheet provides the company with room to manoeuvre but the company does need to return to improved profits to prevent losses impacting the Balance Sheet
   4. A “Water-Skier” (A company kept afloat by its profits, but with a very weak balance sheet) - Insufficient capital? Probably too much dependence on Current Liabilities (payables &/or debt)
      Weak liquidity? NB: Such companies will find themselves in difficulties if profits fall
   5. Their only strength is their Asset Management? Probably good liquidity but weak in all other areas such as low profits, high debt levels, low tangible net worth)

4. P&L Trends 

1. Summary: How have their sales and profits performed over the past 5 years? Are Sales rising or falling? Have profit margins fallen? Is the company retaining profits? Are they making good use of their assets?
2. Look out for:
   1. Are sales rising or falling? If sales are on the rise, are profit margins being maintained. In order to achieve increased sales, usually higher working capital and fixed assets are required and higher levels of assets need to be financed.
   2. Have sales growth been achieved at higher cost levels and lower margins?
   3. Has the overall financial health weakened as a result?
   4. Has the growth been financed with increased reliance on suppliers and/or short-term borrowing, invoice discounting or other short term funding? Increased dependence on short term funding will increase the degree of risk. We quite often find that in cases of rising sales  accompanied by flat or only slightly increased profit levels, the need for increased secure forms of funding have been overlooked.
   5. Weak profit margins - Some sectors (e.g. Motor Dealers) experience tiny margins. This needs to be accompanied by a strong balance sheet to minimise the risk to withstand any drop into losses 

1. Summary: Look out for:  High intangible fixed assets, Net Quick Assets deficit (poor liquidity) and High working capital days
2. Look at the composition of the assets - How liquid is the assets’ structure? Are there significant levels of Intangibles, Fixed assets & Inventory – these are all relatively illiquid? Such assets need to be well funded.
3. Look out for
   1. Large negative quick assets deficit
      This means that more amounts are owed short term to suppliers (creditors) & short term debt than is available from debtors (receivables) and cash. Companies with weak liquidity are vulnerable.
      Note that while this is a weakness, it is not always a problem and quite normal for companies such as food retailers who will compensate for it in other ways (such as good profits or strong net worth).
   2. High number of days working capital
      Some sectors will always have high levels of some or all categories of working capital.
      In many cases high creditors (payables), debtors (receivables) or stock (inventory) days could be highlighting problems:
      Are they taking too long to pay their suppliers/creditors? Suppliers are a cheaper form of finance (no interest charge), but carries a risk, as they need paying within a relatively short period of time.
      Are they managing collection of their receivables in good time? If not, is there an increased risk of bad debts?
      How good is their inventory control? Is too much money tied up in inventory? Is there an increased risk of obsolence and waste?
      While normal working capital days vary from sector to sector, our general rule of thumb for high working capital days is anything exceeding 80 days. Higher levels put a strain on the company unless they have compensating financial strengths.

1. Summary: Look out for:
   ·    Low Net Worth
   ·    High debt, especially short term
   ·    High gearing (debt to equity)
   ·    High Creditors (Payables)
   ·    Intangibles that exceed the Net Worth level
2. Look out for:
   1. Low proportion of funding from Net Worth
      This graph shows how the assets of the business have been funded. In this case the proportion from Net Worth is very low, the level of provisions and long term debt are modest, but the dependence on creditors (payables) is very high indeed.
      The required percentage of funding from Net Worth will vary from company to company but a company with low or deteriorating proportion should be examined with care. Too much dependence on creditor finance is often overlooked.
   2. High intangibles exceed all or most of Net Worth
      In this example, the Intangibles exceed company’s entire Net Worth resulting in tangible negative net worth (liabilities exceed the assets after removing the intangibles). The assets (after removing Intangibles) are insufficient to meet the liabilities and dependent on continuing profits to bridge the gap.
   3. Negative Net Worth
      Obviously companies with base case negative Net Worth, where their liabilities exceed the book value of their assets, are of significant concern and need other compensating factors such as profits or new funding
   4. Too much dependence on creditors (payables) and other short-term funding
      It is sometimes believed that as long as payables and short term borrowing do not exceed the level of receivables and inventory, it does not matter if the short term funding is high. Whilst this is sometimes true, it is not always the case. What is often overlooked is the fact that suppliers expect to be paid promptly. It is not always the case that receivables are paid equally promptly, and that inventory is sold and converted into cash as rapidly as the demands of the suppliers. A company unduly exposed to short-term liabilities becomes very vulnerable to a drop in profits or a drop in sales.

1. The 7 Factor Graphs direct your attention to the strengths and weaknesses that the H-Score model has detected in a company. The figures below each graph identify the financial items which have contributed to the score. Even companies with high H-Scores will not necessarily be strong on all 7 factors. For example, property companies will often be weak on “Current Asset Cover”. Food Retailers will have a poor “Liquidity Factor” because they will have received cash for goods that they have yet to pay to their suppliers. As long as they compensate for this weakness in other ways, such low scores are not a problem. The H-Score model looks at the company as a whole and the result is reflected in the final H-Score. The individual factors provide the explanation of the final score
2. Profit Management
   Measures the profits against the amount that the company has to pay in the next 12 months (Current Liabilities)
   Even where profit levels are good but current liabilities are high, this measure will be depressed
3. Liquidity
   This measures the liquidity of a company (in the form of receivables and cash) in relation to the Current liabilities (that it has to pay in the next 12 months) as well as the annual spend.
4. Stock & Debtors (Inventory & Receivables)
   Too much working capital can mean that the company is not converting its Inventory into Receivables and Receivables into Cash at a fast enough rate & is draining the resources of the company. A weak score indicates that there is insufficient support for the working capital from the long term funding of the business.
5. Current Asset Cover
   Are liabilities too high, or is there insufficient cover from the current assets to meet those liabilities?
6. Equity Base
   This measures the extent to which the capital base (the level of net worth) is sufficient in relation to the liabilities of the company.
7. Current Funding
   A very important measure – measures the extent to which the total assets are funded by Current Liabilities. A low score is telling us that the company has placed too much dependence on its suppliers as well as other short term liabilities and short term borrowing for funding the tangible assets of the business
8. Debt Dependency
   This measures the dependence of a company on outside bank debt. Too much dependence on debt causes strain. A company is penalised for higher levels of short term debt.