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Learning Tree
Management Insights
Expert Advice from Today’s Top Professionals
How Do I Know If I’m Working
for Enron? Three Indicators of a
Company’s Financial Health.
Determining a company’s fiscal health requires a systematic
analysis of available financial information. The following
hypothetical business scenario is the most effective method
for demonstrating this simple process.
Gathering the Evidence
Sue was concerned about her job security. Last quarter, the
company she works for reported increased net income
compared to the same quarter last year. But to Sue, things
just “felt” slower. Fortunately, she had powerful tools to
reveal the company’s “real” condition.
While Enron reported profits right up to the end, even
“creative bookkeeping” couldn’t hide red flags in their
financial statements. Sue could uncover these same warning
signs by reviewing her company’s current and past income
statements, balance sheet and consolidated cash flows.
Checking the Facts
Sue began by checking the company’s gross profits for the
current and previous year, comparing the same quarters in
each year. As reported, the gross profits looked good. But
from the net profits, it seemed as though too much was
being spent on company overhead—specifically the amount
apportioned to service company loans.
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Sue also looked at the company’s margins. From the gross
and net profits, net margins seemed too low compared to
gross margins. However, it wasn’t until Sue plotted the
company’s free cash flow that she realized there were
significant problems.
Ideally, free cash flow should be positive—indicating a
company has cash to pay its bills. Companies sometimes
have to borrow to pay their bills, so free cash flow may be
negative from time to time. However, it is the trend over
years that matters. If the trend is upwards, things are
probably fine. But if free cash flow is trending downwards,
things are definitely not fine.
In Sue’s company, free cash flow was trending downwards.
And in the current year, free cash flow was negative—a very
bad sign. In Enron’s case, for instance, free cash flow had
been consistently negative and trending down.
Assessing the Situation
Taken together, profits, margins and cash flow are good
indicators of a company’s financial health. If any of these
don’t seem healthy, more investigation is required. Sue
decided to find out how much the company had been
borrowing to pay its bills and why. She also started polishing
her résumé.
Richard A. Stanley
Engineering and education consultant Richard A. Stanley provides an
effective method for assessing a company’s financial health in this edition
of our Management Insights series.
CALL 1-800-843-8733
OR VISIT www.learningtree.ca

Learning Tree
Management Insights
Expert Advice from Today’s Top Professionals
Three Indicators of a Company’s Financial Health
Contrary to popular belief, assessing the
general financial health of a company doesn’t
necessarily require an accounting degree.
With basic financial information and a few
easy calculations, you can quickly discover
if your employer is going strong…or barely
hanging on.
Financial Health Indicator #1:
Calculate Company Profits
The first number to look at is the company’s gross
profit from the income statement. The gross profit
is calculated by subtracting the costs associated
with creating product from the sales revenue. Gross
profit measures how efficiently the company carries
out its mission. By comparing gross profit for each
quarter against the gross profit for the same quarter
in the previous year, you can determine if the company
is doing better or worse. You want to compare the
same periods in each year because profit can be
dependent on time of year.
It is possible to improve otherwise lackluster profits
by, for instance, selling some assets to offset lower
sales. You can use the balance sheet to see if assets
are declining from one year to another. This is perfectly
legal and ethical, but if the company is selling assets
that are important to continuing to do business,
then the company’s long-term prospect isn’t good.
Next, look at net profit (it might also be called
net earnings or operating income), also found on
the income statement. Net profit is calculated
by subtracting costs not directly associated with
sales from the gross profit. Net profit tells you how
efficiently the company runs the business. The
company might make widgets very efficiently, as
measured by the gross profit, but waste money on
overhead expenses (a $5,000 shower curtain for
the CEO, for instance). If the difference between
gross and net margins is large, you’ll want to know
where the money in overhead expenses is spent.
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Financial Health Indicator #2:
Measure Profit Margins
If the gross profit is positive, you can calculate the
gross margin—gross profit divided by sales. As with
gross profit, you can compare gross margins for the
same quarters in different years. Are margins stable
or rising? If so, great! If not, decreasing margins
might indicate problems down the road, provided
that your business isn’t cyclical (for instance
steel, automobiles and paper all have good years
followed by bad years followed by good years).
The next step is to calculate the net margin by
dividing the net profit by the sales (the same
sales you used to find the gross margin). As with
gross margin, net margins should be stable or
rising. Net margins will always be less than gross
margins, but should still be large enough to qualify
the company as a “worthwhile investment.”
Financial Health Indicator #3:
Track Cash Flow
Free cash flow is a measure of performance
that is hard to “fudge” and easy to determine.
You calculate cash flow using the consolidated
statement of cash flows by adding net income plus
depreciation and amortization then subtracting
capital expenses. You should calculate the free
cash flow in all the years you have information
for and then compare year to year.
If the trend over the years is level or upward,
and the number is positive in the current year,
things are good. If the trend is downwards, things
could be getting worse. If the trend is downward,
and the current year is negative, things are
already bad—the company is not generating
enough money from its sales to pay its bills.
About the Author
Richard A. Stanley, PhD, PE, is the vice president of Wheeler Associates,
Limited, an engineering and education consulting firm in Boston,
Massachusetts. Dr. Stanley is also a certified Learning Tree instructor and
the author of Learning Tree Course 281, “Finance and Accounting for
Non-Financial Managers.”
CALL 1-800-843-8733
OR VISIT www.learningtree.ca
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