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Golden Rule #1 - Financial Health

Financial Health is our first and most important Golden Rule.

The L Score was developed in 1982 by Lincoln founder, academic and former Olympian Dr Merv Lincoln. Lincoln's unique Financial Health model assesses key accounting ratios relating to each company's profitability, cashflow, liabilities and assets.

Financial Health measures a company’s ability to absorb a shock to its operations should conditions deteriorate at an operational or financing level.

It is our firm belief that without understanding the true fundamental quality of a business, you are purely speculating and at risk of serious loss.

Lincoln’s Financial Health methodology, derived from Dr Lincoln’s PhD thesis, used a multivariate approach, whereby a unique set of financial ratios are calculated, combined and weighted to produce an insolvency risk score representing the overall Financial Health of a company.

Dr Lincoln selected these ratios after analysing thousands of failed and successful companies, to separate low risk companies from high risk companies and isolate indicators of potential failure.

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Model revalidated

The model was refined in 2007 under the guidance of Assoc Professor Neville Norman using newer multi-variate modelling techniques to take into account new ratios that were previously unavailable but are now accessible because of new accounting regulations and reporting standards.

It then determines a Financial Health rating commensurate with the business risk of the company so investors can quickly identify stocks that warrant further consideration and eliminate those that don't.

Understanding the Financial Health of a company must form the basis of all investment decisions. Stock Doctor expertly performs all key ratio calculations enabling you to focus your full attention on making confident and informed portfolio management decisions.

To meet this criterion, a stock must exhibit Strong or Satisfactory Financial Health ratings. A company must be healthy for at least two consecutive periods or more. It is not sufficient for a stock to be healthy for solely one period. 

Two model system

The Lincoln Financial Health methodology uses a two-step system to effectively discriminate the indicators of failed and non-failed companies.

Given that different economics and dynamics govern each industry group, the characteristics of each sector were reviewed carefully to determine the optimal groupings.

The first model applies to the “Real Producers” sector which includes companies in the materials, energy and industrials sector. The other model is for “The Rest” which includes all remaining companies (except Bank and Insurance companies). 

Interpreting Financial Health

While complex in its application, we make understanding the true quality and Financial Health of a business very easy.

There is no need for investors to perform any calculations. Simply follow our overall rating and colour coding to understand the level of financial risk a company is exposed to.

Strong (Blue) and Satisfactory (Green)

Companies rated Strong or Satisfactory pass our first screen and therefore represent the best opportunity for investment consideration. A Strong or Satisfactory rating gives you the peace of mind that the company is most likely to continue as a going concern in any economic downturn, as their balance sheets demonstrate sufficient borrowing capacity and adequate cash levels to finance growth. A healthy business will also be one that generates consistent profits and has produced strong operating cash flows, all underpinning their operational strength.

Their ability to absorb a future ‘shock’ to their business such as regulatory change, economic cycle shift, or poor sales figures, means management can focus on the very important task of managing their business, rather than try to ensure its survival.

Early Warning (Yellow), Marginal (Brown) and Distress (Red)

Companies rated as Early Warning, Marginal or Distress display qualities of failed entities and are therefore not investment grade. They fail our first screen because they have elevated financial risk exposure with a combination of either substantial weaknesses across its profit and loss, balance sheet and cash flow statements. While they may continue as a trading entity due to capital raisings from unsuspecting shareholders, for the company to remain an ongoing entity, substantial changes are needed.  

Bank and Insurance Stocks

Stock Doctor analyses Bank and Insurance companies separately because they operate under a different financial structure to other ASX listed companies. Hence, the Financial Health for the companies in this sector is assumed to be ‘Strong’ as they are already subject to rigorous prudential and liquidity standards and requirements. 

 

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