The new ETF will mimic the stock holdings of the Morningstar Singapore Yield Focus Index. With that in mind, it’s worth spending the time to understand how the stocks are selected. The 30-stock index applies three main criteria to Singapore-listed companies: business quality; financial health; and dividend yield.
Yesterday, we took a look at how Morningstar examines the quality of a business. Today, we will look into …
Phillip Capital Management’s website provided this snippet on how financial health is determined:
“The index screens for companies with sustainable competitive advantage, or Economic Moats in the parlance of Morningstar’s global equity analyst team. Moats protect income stream for erosion.”
Like the first factor, Morningstar does not mention a specific metric they use for this screen. However, the index provider’s website provides some insights into the kind of metrics it uses to check a company’s balance sheet health.
By one measure, Morningstar looks at the possibility that the value of the company’s assets will fall below the sum of its liabilities. If this were to happen, the risk of financial distress is increased for the company. In essence, the index provider wants to ensure that the company has equity value, defined as the difference between the liabilities and assets on the company’s balance sheet.
Other measures of financial health
There are, of course, other ways to measure the balance sheet strength of a company. For instance, we can look at the net cash or net debt position of a company and its debt ratio.
In simple terms, the net cash or net debt position tells investors if the company has more cash or has debt on its balance sheet. Being in a net cash position is better for a company as it means that it can easily pay off the debt on its balance sheet if it needs too. Having cash also gives the company more financial options for the company to grow.
Another metric would be the debt to assets ratio which is calculated by dividing the total debt by total assets. This ratio tells investors, how much of the company’s assets are financed by debt. Said another way, the ratio informs us of the percentage of assets might have to be sold off to pay off all the debt the company has taken.
The financial health of a company can form the bedrock in which it builds a sustainable business. It’s certainly a key factor to look out for in dividend stocks.
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The Motley Fool Singapore contributor Esjay contributed to this article. Esjay does not own any of the shares mentioned.
The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. Motley Fool Singapore writer Chin Hui Leong does not own any of the shares mentioned.