You've read through our abbreviated definitions of various items on the balance sheet -- congratulations. Now we'll have some fun with numbers and play around with these bits of information. We do this to get the nitty-gritty details about how well the company manages its assets and whether or not its price represents a bargain, based on the assets it has at its disposal.
The first tool you use is called the current ratio. A measure of just how much liquidity a company has, this number is simply the current assets divided by the current liabilities.
For instance, if Joe's Bar and Grill has $10 million in current assets and $5 million in current liabilities, here's the formula:
$10 million current assets / $5 million current liabilities = 2.0 current ratio
As a general rule, a current ratio of 1.5 or greater can meet near-term operating needs sufficiently. A higher current ratio can suggest that a company is hoarding assets instead of using them to grow the business -- not the worst thing in the world, but it's something that could affect long-term returns.
You should always check a company's current ratio (and any other ratio) against the same information for its main competitors. Certain industries have their own norms in terms of the current ratios that do make sense and those that do not. For instance, in the auto industry, a high current ratio makes a lot of sense if a company does not want to go bankrupt during the next recession.
When we discussed inventories, we mentioned that sometimes inventories are not necessarily worth the amount they are on the books for. This is particularly true in retail, where you routinely see close-out sales with 60% to 80% markdowns. It is even worse when a company going out of business is forced to liquidate its inventory, sometimes for pennies on the dollar.
And if a company has much of its liquid assets tied up in inventory, it will be very dependent on the sale of that inventory to finance operations. If the company is not growing sales very quickly, this can turn into an albatross that forces the company to issue stock or take on debt.
Because of all of this, it pays to check the quick ratio. The quick ratio is simply current assets minus inventories divided by current liabilities. By taking inventories out of the equation, you can find out if a company has sufficient liquid assets to meet short-term operating needs.
If you look at the balance sheet of Joe's Bar and Grill, you'll see that the company has $2.5 million of current assets in hamburger buns that are sitting in inventory. You now can figure out the company's quick ratio:
Quick ratio = (current assets - inventories) / current liabilities
($10 million current assets - $2.5 million inventories) / $5 million current liabilities = 1.5 quick ratio
Looks like Joe's makes the grade again. Most people look for a quick ratio greater than 1.0 to be sure there is enough cash on hand to pay bills and keep going. Like the current ratio, the quick ratio can also vary by industry. It always pays to compare this ratio to that of peers in the same industry to understand what it means in context.
In addition, some investors will use something called the cash ratio: the amount of cash a company has divided by its current liabilities. This is not a tool to use, however, so we don't have a general guideline if you want to check it. It is just another method to compare companies in the same industry to determine how well they are funded.
For more lessons on reading a balance sheet, follow the links at the bottom of our introductory article.
