Welcome back to the second session of the Ratio Analyzer workshop.
If you've been reading along, you'll note that this workshop is also a shakedown cruise for the new Ratio Analyzer. Thanks to Saul Seinberg, we've experienced some shaking, and have repaired a bug in the report.
Now let's look at some of the details.
This session examines the Liquidity Ratios section of the report.
If you look up the definition of liquidity, you will find something like this:
"The ability of an asset to be converted into cash quickly and without any price discount."
In the context of analyzing a company, liquidity refers to a company's ability to come up with the cash that it needs, when it needs it. This can be to pay off debt, stave off creditors or bankruptcy, etc. Another way of looking at this is ... if the company needs to come up with cash to prevent something dire from happening, does it have the resources to do that.
Our Online Help has this to say:
"A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern."
There are five items in the Liquidity Ratios section of the Ratio Analyzer report:
- Working Capital Ratio (also known as the Current Ratio)
Working Captital Ratio = (Total Current Assets)/(Total Current Liabilities)
If this number is greater than one, it means that the company can pay off it's current liabilities using current assets. This wouldn't be the preferred way to pay current liabilities, but it would be possible. And, as our Online Help observes, "It's generally a good idea to own more than you owe." The Quick Ratio, below, looks at the ability to pay off current liabilities, without having the need to liquidate items like inventory, buildings and equipment.
- Long-term Debt (annualized change)
Long-term Debt Change = 100*( ( (Long-term Debt This Quarter)/(Long-term Debt 4 Quarters Ago) ) -1 )
Subtracting 1 from the ratio gives the fractional change. Multiplying by 100 converts the change to a percentage change.
Long-term debts are those debts that have a maturity of greater than a year. A company doesn't have to pay them off this year, but will have to pay in the future. The company generally does have to pay interest on the debt.
In this item, we look at the trend in the company's long-term debt, so we compare this year to last year. The number shown in the report is the percentage change in the debt from last year to this year. Is the company taking on more debt? If so, the result is positive. If the long-term debt is decreasing, the result is negative. Normally, we want the long-term debt to decrease, but we do recognize that management may choose to take on debt to grow the business.
- Long-term Debt to Equity Ratio
Long-term Debt to Equity Ratio = (Long-term Debt) / (Total Equity)
Here we are interested in the company's ability to pay off the long-term debt when it comes due. Normally, the long-term debt will by paid off out of operating revenue. In bad times, though, debts may have to be paid out of the equity in the company.
A good rule of thumb is that 25% is the largest number that you would like to see for debt to equity ratio. But, you should be aware that different industries have different demands, so this number may also be dependent on the company's industry.
Total Interest Coverage = (Pre-Tax Profit)/(Total Interest Paid on Long-term Debt)
In the discussion above, it was mentioned that the interest on debts is paid out of the company's treasury. Normally, this is paid out of operating revenue. Here, we compare this specifically to the Pre-Tax Profit, the money left over when all other expenses are paid that can be used to pay the long-term debt. We'd like this to be as small as possible. LARGE so that paying interest on the long term debt doesn't limit the companies other financial activities. Values greater than 5 are considered to be good, while values less than 3 are considered to be bad. The Total Interest Coverage tells us how many times that interest on the long-term debt can be paid using Pre-tax Profit. Our working rule is that any number greater than 5 is good (less than 20% of pre-tax income goes to paying long-term debt), that a number less than three is worrisome, and that numbers between 3 and 5 require investigation.
- Quick Ratio (also know as the Acid Test)
Quick Ratio = ( Cash + Marketable Securities + Accounts Receivable (net) ) / ( Current Liabilities )
The Quick Ratio is viewed as a rather severe test of a company's ability to raise cash to cover short term obligations. You can compare the Quick Ratio to the Working Capital Ratio. Whereas the Working Capital Ratio includes all of the company's assets, the Quick Ratio uses only those assets that could be converted into cash quickly to cover current liabilities.
Let's take a quick look at some specific companies, focusing on the most recent quarter.
Microsoft (MSFT) looks pretty good, and it's due to the fact that Microsoft has NO DEBT! The one caution for Microsoft is that the Working Capital Ratio falls short of 2, the value that we would like to see for a manufacturing company. For comparison, take a look at Google (GOOG).
Airgas (ARG) is a company that shows up on the StockCentral Screener as a good quality company with a Take Stock Quality Rating of 6.8. The Ratio Analyzer, though, shows some financial concerns: every item in the Liquidity Section calls for caution or warning. The company's long-term debt has nearly tripled from a year ago, and the Ratio Analyzer suggests that the long-term debt may be excessive.
If you are interested in a particular company, it might be smart to look at that company in terms of the Ratio Analyzer's results. What companies are you looking at? What do you see that comforts or frightens you? |