### Financial Strength

The financial strength of a company is quite possibly the most important overall determining factor as to whether it will survive and even more importantly, thrive.

Not only must we take into account the “standard” financial measure of profit, revenues, operating cost how the business is performing but also how likely a company is to face financial distress. In other words, sustaining this success needs to be factored in when picking stocks to add to a watchlist. However, we must look at a company’s financial strength as how strong it is in terms of the protection of its capital, assets and overall cash position. This is a different approach to simply avoiding stocks which are at high risk of fraud or bankruptcy.

Of course, the risk factor of a fraudulent company or one which is likely to go bankrupt should be considered, but we also need to see how strong a company and its stock can be from a profitability, leverage and efficiency point of view. This is crucial due to the fact that fraud and the likelihood of a company going bankrupt can sometimes be difficult to detect in isolation, even with the assistance of advanced formulae. This is where taking into account these factors in addition to the financial strength of a company can give a more wholesome picture of the investment in question.

Put simply, the stronger a stock, the higher likelihood it can withstand the many unknowns of the economic world including market conditions and competition.

##### Piotroski Fundamental Score (F_Score)

The Piotroski Fundamental Score (or F_Score) is a measure used to analyze and come to a determination on how strong a company’s financial position is. It was created by Josesph Piotroski, an accounting professor and it takes into account nine different aspects based on accounting fundamentals over a period of several years. On each successful fundamental, the stock receives a point.

The result of this score is a number between 0 and 9, with 9 being the best score and 0 being the worst.

From a valuation point of view, a score above 8 would be seen as a high value company, with a score between 0 and 2 being a company one would most likely want to avoid.

This can be a very effective way of finding valuable stocks as opposed to just those that are cheap, as majority of these cheap stocks are unlikely to be value stocks as well.

##### Category Breakdown

The F_Score consists of several categories as follows:

Profitability.

Leverage, Liquidity and Source of Funds.

Operating Efficiency. ** **

##### Profitability

The criteria for this section is further broken down by four variables which give us an insight into the profitability of a stock and cash flow situation. 1 point is awarded if the below values for each variable are greater than 0. If not, then 0 points are awarded.

The four variables are as follows:

##### Return on Assets (ROA)

*ROA = net income before extraordinary items and cash flow from operations/beginning of year total assets. *

##### Cash Flow from Operations (CFO)

##### Change in the Return on Assets (∆ROA)

This is calculated as the current year’s ROA – prior year’s ROA.

##### Accruals (ACCRUAL)

*ACCRUAL = stock’s current year’s net income before extraordinary items less cash flow from operations, scaled by beginning of the year total assets. *

##### Leverage, Liquidity, and Source of Funds

According to the F_Score, the health of a company is considered in poor condition if there are signs of more borrowing/higher debt levels, poor liquidity levels and the obtaining of financing from external sources. In line with the above factors of leverage, liquidity and source of funds, there are three measures which can be taken into account to gage whether a stock will be able to ride the wave and commit to its financial promises. These are as follows:

##### Long Term Debt Level Changes (∆LEVER)

This is a measure of the historical change in the ratio of total long term debt to average total assets, with any signs of leverage being seen as a negative, and reduced or substantially lower than average leverage being seen as a positive for the stock overall. According to the F_Score methodology, if the leverage ratio fell the previous year, 1 point would be awarded, otherwise this would remain 0.

##### ∆LIQUID

This is a measure of the historical change in a company’s current ratio between the current and previous year, whereby the current ratio is the ratio between current assets and current liabilities at the end of the financial year. As explained by Potrowski in his 2002 book Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, “I assume than an improvement in liquidity (i.e. ∆LIQUID greater than 0 is a good signal about the firm’s ability to service current debt obligations. The indicator variable F_∆LIQUID equals 1 if the firm’s liquidity improved, zero otherwise”

##### EQ_OFFER

The EQ_Offer assesses whether equity has been issued by a company in the year leading up to the formation of the portfolio. If no “common equity” is issued, the value of this is 1, otherwise it would be given a score of 0.

##### Operating Efficiency

The final two measures assess any efficiency changes related to the operating efficiency of a stock or business. They consist of change in margin or ∆MARGIN and change in turnover or ∆TURN.

##### ∆MARGIN

*∆MARGIN = Current Gross Margin Ratio – Previous Year’s Gross Margin Ratio*

Whereby Gross Margin Ratio = Gross Margin/Total Sales

According to Piotroski, any improvement in the margin of a stock translates to a stock whose costs are improving or there is an increase in the price of the company’s core product. This would naturally be a positive for the stock overall.

The F_Score would award 1 point it the ∆MARGIN value is a positive figure, with 0 points for a negative figure.

##### ∆TURN

##### ∆TURN = Stock’s current year asset turnover ratio – previous year’s asset turnover ratio.

Whereby asset turnover ratio = total sales scaled by the beginning of the year.

This would suggest that any asset turnover improvement means that there is generally more company efficiency as a result of the assets being more productive, or there has been a boost in revenue/sales. F_∆TURN is noted as 1 if the value is positive, and 0 if negative. ** **

##### F_SCORE – Understanding The Formula

The F_SCORE is calculated by adding the signals described above to give a numerical result. Therefore:

*F_SCORE = F_ROA + F_ROA + F_CFO + F_ACCRUAL + F_∆MARGIN + F_∆TURN + F_∆LEVER + F_∆LIQUID + EQ_OFFER *

##### F_Score Application & Real World Use

As we have seen the F_Score is an extremely useful and deeply analytical tool which can help assess a company’s financial strength and as a result help identify a valuable investment. Therefore, this can be used to identify and filter the best companies in the top 10 percentile which qualify based on the methodology of the F_Score and, ultimately, create an extremely high quality watchlist of stocks which have been hand picked as those with the strongest financial standing.

##### Microsoft Real World Example

If we take the example of Microsoft, we can pull the data required and input said data into the F_Score formula as follows:

- Net Income: $44.28B
- ROA:15.1%
- Cash From Operations: $60.68B
- Microsoft’s Long Term Debt Current Year: $59.58
- Microsoft’s Long Term Debt Previous Year: $66.66
- Microsoft’s Current Ratio Current Year: 2.5x
- Microsoft’s Current Ratio Previous Year: 2.5x
- Shares Issued In The Last Year:0
- Gross Margin Current Year: 38.2%
- Gross Margin Previous Year: 37.8%
- Asset Turnover Ratio Current Year: 0.9x
- Asset Turnover Ratio Previous Year: 0.7x

Taking into account the above figures, a score can now be given for all the components of the F_Score to leave us with a total result.

Net Income value higher than 0 : 1 point

ROA value higher than 0: 1 point

CFO value higher than 0: 1 point

CFO value greater than Net Income: 1 point

Long Term Debt Current Year less than Long Term Debt Previous Year: 1 point

Current Ratio Current Year greater than Current Ratio Previous Year: 0 points

No New Shares Issued In The Last Year : 1 point

Gross Margin Current Year greater than Gross Margin Previous Year: 1 point

Asset Turnover Ratio Current Year greater than Asset Turnover Ratio Previous Year: 1 point

The above would give Microsoft an F_Score of 8/9, comfortably putting it in the top 10 percentile of stocks if not the top 5 percentile. Therefore, this shows how using the F_Score can help find top scoring stocks thus further enhancing the quality of the watchlist.

##### FS_Score

In their book Quantitative Value, T. Carlisle and W. Grey further enhanced the F_Score with their own metric called the FS_Score.

This score works in the same way by awarding 1 point for each criteria that is met by a stock, but taking into account 10 metrics instead of 9 with the F_Score.

The FS_Score consists of three categories which are: current profitability, stability and recent operational improvements.

##### Current Profitability

Carlisle and Grey discuss how they use three variables in order to gage the profitability of a stock and its current cash flow position.

*ROA = net income before extraordinary items*

*FCFTA = free cash flow/total assets for the past year*

If the ROA is positive, 1 point is awarded and 0 if it is negative. This measure is expressed as FS_ROA.

If the FCFTA is positive, again, 1 point is awarded.

The difference between the FS method and the F method is that instead of CFO as a variable, Carlisle and Grey use FCFTA. Their reason behind this is to allow for the effect of capital expenditures on the cash flow of the company.

##### Stability

The ∆LIQUID and ∆LEVER variables are the same as the F_Score, however Carlisle and Grey talk about the replacement of EQ_OFFER with net equity issuance (FS_NEQISS).

*FS_NEQISS = equity repurchases – equity issuance. *1 point is awarded if the equity repurchases exceed equity issuance and 0 if not.

##### Recent Operational Improvements

In addition to the variables outlined by Potrowski and the F_Score, Carlisle and Grey also take into account the ∆ROA and ∆FCFTA value. Therefore the variables which they consider relevant to recent operational improvements are:

*∆ROA*

*∆FCFTA*

*∆MARGIN*

*∆TURN*

##### FS_SCORE – Understanding The Formula

As mentioned above, the FS_Score takes into account 10 factors as opposed to the Potrowski score’s 9 where:

*FS_Score = Sum (FS_ROA, FS_FCFTA, FS_ACCRUAL, FS_LEVER, FS_LIQUID, FS_NEQISS, FS_∆ROA, FS_∆FCFTA, FS_∆MARGIN, FS_∆TURN)*

Both the F_Score and FS_Score are similar due to the large number of exact variables used in both scores, however in their book Carlisle and Grey believe that “the FS_Score is more intuitive and grounded in value investing philosophy than the F_Score.”

##### Summary

By assessing a stock’s financial strength, we can take analyze and assess its ability to hold onto its current capital and maximize on its strengths to stand out from the competition both from a market share point of view, but also from the point of profitability. The F_Score, as we have seen, enables investors to “weed out” stocks which are either currently underperforming or likely to struggle to perform in the long run. This is done by combining based on a stock’s profitability, operational improvements and overall stability, thus resulting in a financial health score. Carlisle and Grey further enhanced this by creating their own version, the FS_Score which tweaks the F_Score to provide a more in depth view into these areas.