A few days ago I wrote an introductory article about the importance of using financial ratio analysis in picking stocks. In today's article I want to examine some common liquidity ratios and explain what you can find out about a company and a stock from those ratios. Liquidity ratios are all meant to help us determine how well a company can meet its short-term debt obligations. In general with these numbers, the higher the number, the larger the margin of safety a company has in its ability to meet maturing short-term debt obligations. I will examine the two major liquidity ratios and what they mean to you as an investor, and what they mean to creditors as well.
The current ratio is the most widely used liquidity ratio. The formula for the 
current ratio is current assets/ current liabilities. Both of these numbers come directly from the balance sheet of the company. In this case, a ratio under 1 indicates that the company would be unable to pay off its debts if they came due at this point. Let's look at an example. From the balance sheet we see that Cisco Systems, Inc. (NASDAQ: CSCO) had 25,676,000 in current assets (this is the number used in balance sheets, represented in thousands) and 11,313,000 in current liabilities, so we divide those numbers to find our current ratio of 2.27 for Cisco. This is the sign of a company that is very well equipped to pay off its short-term obligations. The current ratio is most useful to creditors, who are obviously very interested in knowing the ability of a company to pay off its obligations.
The second liquidity ratio commonly used is the quick ratio. The quick ratio is the same as the current ratio except it includes inventories. The formula becomes current assets - inventories / current liabilities. The quick ratio is the more conservative of the two major liquidity ratios. In the modern financial era, the quick ratio is gaining more and more traction because many companies are unable to convert their inventories to cash quickly enough to pay off short-term obligations. The current ratio has the tendency to overestimate a company's ability to meet its obligations, while the quick ratio shows a more true picture.
How can you use these ratios to help you in your stock picking? These two ratios are most applicable when valuing new or small companies, or turnaround stories. I always like to measure the liquidity ratios of smaller unproven companies even more thoroughly, since these companies usually have a greater amount of short-term obligations in relation to the assets at their disposal. It is also important to measure the ability of turnaround stocks to meet their obligations. When a company has had a financial hardship, its balance sheet may not look very pretty, so liquidity ratios must be measured extra carefully.
The liquidity ratio is most useful to creditors, but can also be used to measure the financial strength of a stock. It is essential that a company keep its assets and liabilities in check since not doing so would clearly lead to their eventual bankruptcy. In the coming weeks we will examine how to use profitability ratios, activity ratios, and debt ratios to help you find the best stocks.
Comment Preview