This is the second part of my guide on how to understand and interpret the key financial ratios that will guide how you invest profitably in companies. If you missed the first part, go to this link. If you have already read that, then let’s get you started on Part 2 of Understanding Financial Ratios.
Other than profitability ratios, liquidity ratios are the most popular types of fundamental analysis that investors will use. Liquidity ratios help measure how well a company will be able to meet any of its obligations in the near term. You can see why this is important for creditors.
As you probably already know, a company’s current assets refers to items such as the cash in its bank accounts, accounts receivables, inventory and others. The current ratio measures how well the company can pay off its short term liabilities if it had to liquidate its current assets (turn its current assets into cash).
If the current ratio is too low, it is an indication that the company may not be able to pay its current debts and that you should look further into it. For example, if a company has a current ratio of 0.88x, it means that if it were to liquidate all of its assets at its book value, then it would only be able to cover 88% of its current liabilities.
A company with a higher ratio means that it would have no problem paying its immediate debts. However, it could also mean that the company is carrying way too much inventory. Or, that their accounts receivables is too much and that they are not following up on payments quickly enough. It all depends, and you need to dig deeper.
Cash ratio examines the most liquid assets that a firm has such as cash and short-term marketable securities. You divide these by current liabilities. Use this if you want to be even more conservative.
For something tougher than the current ratio, use the quick ratio. This ratio will help you compare the company’s short-term securities, accounts receivables and cash to its current liabilities. Those who prefer calculating this argue that the quick ratio is the most accurate way to determine how liquid a company is.
One of the major differences between the quick ratio and the current ratio is that the current ratio does not include inventory. The argument is that in times of difficulty, a company is going to have a tough time selling its inventory anyway.
Where liquidity ratios measure a firm’s ability to meet its short term liabilities, solvency ratios examine how well a company will meet its longer-term obligations. It looks at the firm’s capital structure and how well it is using financial leveraging.
This is the easiest ratio to understand – just a measurement of the percentage of a firm’s total assets that is financed by borrowings. If you see a larger number, then that means that the firm is using a lot of debt to buy assets, which in turn puts it at risk with regards to interest payments.
A company’s debt to capital ratio measures a company’s total capital that is powered by its debt, both short and long. Sure, more debt means that there is a higher risk with regards to fixed interest payments. On the other hand, it also means that there is less dilution of ownership and that you may earn more per share.
These are some of the more popular financial ratios that myself and many of my friends use when considering whether to invest in a company or not. Did we miss anything out? How would you judge the financial health of a company? Let us know in the comments below: