The way to measure a good business is the same as measuring a good investment. As a result, many successful people with a background in business make an easy transition into growing their capital through investing.
In a previous post, I shared how to use profitability ratios utilized in accounting to find superior investments. This post will cover the second part of that, using liquidity ratios to measure the health of any business, which will in turn help you discover the best long term investments.
There’s a couple of things to consider when it comes to liquidity ratios. Firstly, liquidity is obviously a good characteristic for any type of business. While it’s chiefly important for financial banks, who depend on liquidity to cover any customer withdrawals and other expenses, it’s also crucial for every business.
Every business has a certain number of expenses that are required for the business to run. Some of them might be day-to-day, while others are longer term or sporadic. Regardless of the exact situation, every business must have a minimum amount of liquidity to keep the business running smoothly.
Understanding this concept will help you understand why liquidity ratios are so important. Take the example of a company who isn’t liquid. While running more liabilities than assets isn’t in any way sustainable, a company could continue to run for many months into the foreseeable future– by issuing more debt or increasing earnings in a short period, or making other tough but necessary decisions. This can go on for quite a while until something unexpected arises.
Now take the same example and imagine what would happen if the world economy moved into a recession. During a recessionary time, earnings at companies across the exchange would lower as spending decreases and de-leveraging starts to take place.
What happens is that companies who are highly levered will start to default on their loans, as lowered earnings makes them unable to make minimum payments. Then financial banks, who are the most levered industry in the market, will also lose earnings from consumer loan defaults. A bank without sufficient liquidity will also default in such a situation, causing a ripple effect with enormous ramifications across the economy.
Liquidity Ratios Are Essential for Survival
Of course, these same liquidity requirements that a prudent bank should consider also applies to any business with liabilities and assets. While it’s frequently better to be more conservative than not in this regard, many businesses sacrifice the safety of liquidity in order to pursue faster growth and greater short term profits.
However, I’m telling you that this is the case. Knowing that companies make these decisions, you should also realize that as an investor, you have all the power to decide how much liquidity you want your invested capital to have. That’s what liquidity ratios can show you. By using this ratios, you can quickly calculate how liquid a company is. This can help keep your investments safe, if you just invest in highly liquid companies.
Just as you wouldn’t want to buy a company with a lot of debt, you shouldn’t throw your money away into investments where companies are highly leveraged. Sure it might be exciting for a while, but history continues to prove that the high flyers also fall hard.
The whole premise behind this idea of liquidity is why I wrote the book: Value Trap Indicator. In there, I prove that the biggest bankruptcies could’ve been easily avoided by looking at a few numbers in a company’s balance sheet.
The balance sheet is where a company’s assets and liabilities are disclosed, which will tell you how the long term health of a business is looking. The liquidity ratios I’m about to share with you will help do the same thing.
It’s my hope that you’ll learn something about liquidity with this post and use it to protect your capital. No matter what you do for a living, you’ll likely have to make decisions about where to put your hard earned capital. Taking a conservative business approach to your investments will prove to be a valuable life skill that can compound your wealth over time. Use it.
Like I mentioned before, the difference between a company’s assets and liabilities is a major factor in determining how liquid a company is. It will tell you how able the company is to pay its bills. When looking at assets and liabilities, it’s helpful to concentrate on current values.
That’s where working capital comes in. Working capital, also known as net working capital, is simply the difference between current assets and current liabilities. While the long term health and value of a company can be measured by the book value, or total assets minus total liabilities, the short term health can be easily expressed with amount of working capital.
A great way to measure the ability of a company to cover short term liabilities is with the current ratio. Current ratio, also called working capital ratio, is calculated by dividing the current assets by current liabilities. Or for those who need a visual:
Current ratio = (current assets) / (current liabilities)
The validity of this ratio should be obvious. If times got tough for a business, the worst thing that can happen is that it would need to sell off its assets to cover its liabilities. A company with a good current ratio would have plenty of remaining assets left over after liabilities were paid to still create a sufficient income for the business.
A current ratio of 2 or greater is widely accepted as an indication of strong company health. Any current ratio less than 1 indicates that a company has less assets than liabilities in the short term. Now, this might be bad news, but it also depends on the long term health.
Debt to Equity Ratio
That’s where the debt to equity ratio comes in. While not traditionally considered as part of the “liquidity ratio” group, debt to equity is the most valuable metric for evaluating for a strong balance sheet (in my humble opinion).
Time and again, my research with the Value Trap Indicator book proved that a high debt to equity ratio was one of the most common characteristics of a company about to go bankrupt.
Debt to equity is a pretty simple calculation as well. You divide the total liabilities with the shareholder’s equity, which is just total assets minus total liabilities. A debt to equity less than 1 is preferred, which shows that all debts could be easily covered in a time of hardship.
Debt to equity = (total liabilities) / (shareholder’s equity)
I really like companies with a debt to equity of below 0.5 or even 0.25 if I can find it. A number like this shows that the company is 2x and 4x covered, with the same security effect as a current ratio of 2 or 4. But of course, remember that the current ratio is dealing with the short term while debt to equity is more long term.
So if a company has a current ratio lower than 1 but still has a great debt to equity, it might still be a good investment to consider with a watchful eye. However, if the company has a low current ratio AND debt to equity ratio, think twice because that company is NOT safe.
The next liquidity ratio to consider is called the quick ratio, or acid test ratio. You calculate this value by subtracting the inventory from current assets, and then dividing by current liabilities.
Quick ratio = (current assets – inventories) / (current liabilities)
This is a more precise calculation than the current ratio done above. The concept is the same however; if a company is closing down and liquidating all of its assets, how great is their ability to cover liabilities. The quick ratio will tell you exactly that, especially because inventory can’t be instantly sold in such a scenario. This is why inventories is subtracted.
Like the current ratio, the quick ratio is attractive at above 2, though 1.5 is still sufficient. A quick ratio of 1 is technically sufficient, while a quick ratio below 1 can reflect some trouble.
The last liquidity ratio to consider is the operating cash flow ratio, which is also commonly referred to as the cash ratio. This ratio will display how much straight cash a company has relative to its short term obligations.
To calculate operating cash flow ratio, simply divide the cash and cash equivalents figure shown in the balance sheet by current liabilities.
Cash ratio = (cash and cash equivalents) / (current liabilities)
This measurement is strictly dependent on current cash, and as such is the toughest requirement of all the ratios here. Though it could technically be a very useful measure, in fact it doesn’t do much for determining true health.
A company that is otherwise very successful, producing surpluses of capital and covering all liabilities with assets, might have temporarily shortfall of cash for one reason or the next. This isn’t means for panic, but it will display a low cash ratio in the meantime.
As you can imagine, this last ratio isn’t widely used in stock market analysis particularly for the reason highlighted above. A company may very well stumble into a windfall of temporary cash, with the same lack of temporary cash just as possible. As such, the usefulness of the cash ratio is limited, but it’s still good to know in case you ever run across it.
There are opportunities out there, simply because enough people don’t know of the possibilities. So take some time and really learn how to analyze a business. Learn the difference between a company in trouble, and a company that’s not– especially if this numbers stuff interests you.
At the very least, you’ll be mildly entertained and better informed. At the very most, you might even build a fortune.