All 1,700 companies covered in The Value Line Investment Survey have a Financial Strength rating, with ratings ranging from an A++ for the most financially stable firms, to C, for companies that are in serious financial difficulty. There are a number of key factors that determine the Financial Strength rating of a corporation.
The amount of debt on the balance sheet is one of the most important issues. Generally speaking, the more debt a company has on its balance sheet, as a percentage of total capital, the lower the Financial Strength rating. As debt rises, a company’s ability to meet its ongoing obligations, particularly in an unfavorable economic environment, is reduced. On the other hand, a strong balance sheet, with little or no debt, typically means that a corporation has the ability to manage or expand its operations without much difficulty. It also supports a concern’s ability to make dividend payments on a timely basis.
Other important factors that go into a Financial Strength rating include business risk and the level and direction of profits. Clearly, a company with strong profit gains in recent quarters would have the ability to meet its obligations and would likely have the cash flows necessary to expand operations to support rising demand. The greater a company’s business risk, the lower the Financial Strength rating. Cash on the balance sheet is another important contributor to the rating: in most cases, the more cash on hand, net of debt, the better the rating.
The Dow is a stock market index that includes 30 large, publicly owned and actively traded issues based in the United States. Given that these companies are all relatively large, from a market capitalization perspective, most have strong Financial Strength ratings. In general, bigger companies that have large amounts of cash on hand, are healthier and more stable than smaller concerns.
Microsoft (MSFT - Free Anaylst Report), the software giant, is a component of the Dow 30, and maintains our Highest Financial Strength rating of A++. The company has a market cap of more than $210 billion. It also has a strong balance sheet, with nearly $37 billion of cash on hand as of June 30, 2010. This allows it to easily fund its capital spending and dividend obligations, without the need to tap into the debt or equity markets. It also has a small amount of debt ($6 billion), comprising just 9% of total capital. The company has solid and consistent cash flow and profit growth potential, as well. Even during the 2007-2009 recession, Microsoft managed to report solid bottom-line growth and increased its dividend payments.
While most of the Dow 30 companies have a Financial Strength rating of A or higher, some do not. Alcoa (AA - Free Analyst Reprt) has a market cap of more than $12 billion which, by Value Line standards, is considered large cap, but is still significantly smaller than Microsoft. It carries a Financial Strength rating of B+. Debt is roughly 40% of total capital, a significantly larger percentage than for Microsoft. The company also reported operating losses for a few quarters in the past couple of years, and this has hurt its ability to generate strong cash flows. As a result, the aluminum giant cut its quarterly dividend from $0.17 per share to $0.03 per share in June of last year.
Overall, the financial health of the majority of the Dow 30 companies is very strong. Even the handful of entities that are not rated A, or higher, are in decent financial health, with no company posting a Financial Strength rating below B+. We note that Financial Strength does not necessarily translate into an outperforming stock. Many smaller companies, with weaker financial health, tend to outperform larger corporations when the economy is rebounding from a recession. Moreover, Financial Strength doesn’t necessarily correlate with share price volatility, so the stock of a company with an A++ rating could well be more volatile than the stock of a company with a much lower rating.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.