The balance sheet is arguably the most important financial statement when crisis hits, and there are some ratios you have probably passed over that are tremendously important.
With the current market correction, we are starting to see more investors using the balance sheet. A problem from this, is that many new investors don’t know how to read a balance sheet past the basic metrics.
As so many people are flocking to the balance sheet, it is useful to know a company’s capital structure and liquidity to determine how long they can last during the current pandemic.
Some of the most looked over metrics can be super useful to an investor, and they don’t even know it.
The current ratio compares all of a company’s current assets to its current liabilities. As a definition, these are assets that are cash or will be turned into cash in a year or less, and liabilities that must be paid in a year or less.
Current Ratio = (Current Assets) / (Current Liabilities)
By looking at this equation, it seems pretty clear that we want the company’s ratio as high as possible, indicating that they have a higher amount of assets compared to liabilities.
Microsoft (NYSE:MSFT) for example, is a company with a great ratio. At the end of 2019, they had a ratio of 2.53. On the other hand Carnival Corporation & PLC (NYSE:CCL) had a ratio of 0.23
To put these ratios into perspective, Microsoft would be able to pay for all of its liabilities with its current assets, and still have plenty of cash left over. Carnival on the other hand, would have to make up tons of cash in order to pay its debts.
The higher the number the better, with over 1 being they have more current assets than current liabilities. This is important to understand their short term liquidity during a time of crisis, like a pandemic.
Something to consider is the sector average. Comparing the sector average and the company’s average can show the true health of a company’s current ratio, as some sectors have totally different averages.
Another thing to take into account is that the current ratio incorporates all of a company’s current assets. Two companies may have the same ratio, but company A can have 75% of that ratio in inventory, while company B has 75% in cash.
Company A’s inventory may be hard to liquidate as it may be stock that was hard to move, and will be in turn discounted, reducing its value on the balance sheet. So in this case, company B would have a stronger current ratio.
Super important during a crisis is the cash ratio. It is not as common as the first two ratios, but it has a major importance right now. The cash ratio is a liquidity measure that shows a company’s ability to cover its short-term obligations using only cash and cash equivalents.
Cash Ratio = (Cash + Cash Equivalents) / (Current Liabilities)
The cash ratio is the most conservative liquidity ratio as it only considers the company’s most liquid resources. In a time like this crisis, the cash ratio is essential as it can tell investors the ability for the company to cover its liabilities over the course of the next year, without having to liquidate its assets.
A low ratio is not desirable as a company would have to liquidate assets in order to fund their liabilities. On the flip side, a high ratio isn’t necessarily good, as it can signify that a company has poor management of their cash and isn’t reinvesting into the business, or the company is worried about future profitability and is creating a protective cushion.
This ratio is an important ratio right now, but in a normal market, it isn’t as useful. It is not realistic for a company to carry tremendous amounts of cash, so a ratio just above 1 is desirable.
Microsoft had (in millions) $133,819 in cash and equivalents at the end of 2019, with only $69,420 in current liabilities. So Microsoft has more than enough to cover their backside during this pandemic.
Total Debt to Equity (D/E)
Total debt to equity is used to evaluate a company’s financial leverage. It reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
Total Debt to Equity = (Total Liabilities ) / (Share Holder Equity)
For this ratio, we want it to be low.
A high ratio indicated higher risk, but a company taking on more debt in order to try to grow their revenue can be a great reward. Of course, this is a highly risky maneuver.
It’s almost impossible to compare debt to equity for companies of different sectors as different sectors have different averages of debt needed to take on in order to grow.
Net Working Capital
Net operating working capital is a measure of a company’s liquidity and refers to the difference between operating current assets and operating current liabilities.
Net Working Capital = Current Assets - Current Liabilities
From the equation, it’s evident that we want a higher number. If a company has positive working capital, then it has the potential to invest and grow. If a company has a negative working capital, then it may have trouble paying its debts, or even go bankrupt.
The Bottom Line
With the current market due to the global pandemic, we are seeing liquidity issues in companies. Because of this, people are flocking to the balance sheet in order to decipher if companies are going to be able to make it through these hard times.
Unfortunately, lots of investors are skipping over some of the best liquidity metrics there are, mainly being the quick ratio, cash ratio, current ratio, debt to equity, and net working capital.
With these ratios, you will be well equipped to determine for yourself if companies are liquid enough to survive this economic downturn.