Having addressed the use of profitability ratios to determine a business’s profitability, we now turn to another key aspect of fundamental analysis—liquidity.
Just as an unprofitable business cannot survive, one with little liquidity cannot last either. One lesson of the credit crisis has been that sound businesses that overextended themselves collapsed when liquidity disappeared. Therefore, when selecting stocks to invest in, we must assess a company’s financial position.
When examining liquidity we focus on three ratios: the cash ratio, the quick ratio, and the current ratio. To calculate and understand each ratio, see the following:
1. Cash Ratio – The cash ratio is calculated as follows:
(Cash + Marketable Securities) / Current Liabilities
This is the most conservative of the liquidity ratios. Current liabilities are debts a company must pay within one year. By comparing them versus the amount of cash and cash-equivalents a company owns, we can see how readily the company could pay off short-term obligations. A cash ratio greater than 1 indicates the company has more cash than current liabilities. Most companies have a ratio between 0.15 and 0.30.
2. Quick Ratio – The quick ratio is calculated as follows:
(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Accounts receivable are loans extended by the company for the purpose of purchasing the company’s goods and services. They typically are short term and paid back on a regular basis. The quick ratio assumes that these receivables can be converted into cash that is used to pay off liabilities. A company with solid liquidity will have a quick ratio in excess of 1.
3. Current Ratio – The current ratio is calculated as follows:
Current Assets / Current Liabilities
This ratio assumes that all current assets can be converted to cash in a short time period. In reality, the timing and ability of companies to do so is questionable. While the current ratio is the most commonly mentioned of the three ratios, it also offers the least amount of security to a new investor. Reject any company with a current ratio below 1 and focus your attention on those companies with a current ratio of 1.5 or higher.
Just as a company needs profitability to grow, they also require liquidity to survive. By analyzing a company’s balance sheet, we can avoid the unpleasant surprise to our portfolio that occurs when a healthy business goes bankrupt by running out of cash.
See also 3 great profitability ratios for fundamental investing.
Sean Hannon, CFA, CFP is a professional fund manager.
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