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As engaging as investing can be for many of us, it's not a passion we want to consume all our waking hours. One difficulty many long-term investors struggle with is how to gain an ongoing level of comfort with an investment after the initial purchase. Most of us aren't professional stock investors -- we're investing money that we've generated in other careers.
While I personally believe that learning to read financial statements closely is the single best way to empower yourself as an investor, not everyone has the time or inclination to pick up this skill. Short of poring over the numerous line items of an income statement, what's the best way to evaluate stock holdings without obsessing on a daily basis? Understanding and using financial ratios is an excellent method for keeping track of equity investments. And learning to check up on your investments periodically, with the confidence to make useful decisions, can be incredibly liberating.
A simple framework explained
Here's a secret that could benefit by exposure to a little sunlight: The vast and complex discipline of analyzing financial statements isn't actually that vast and, for the most part, it's not even that complex. Modern financial statement analysis addresses four distinct areas. It's helpful to think of each of these areas as answering a big picture, common sense question about the organization being studied. The framework is as follows:
Liquidity: Does the company have sufficient cash or other means to meet short-term obligations?
Profitability: Is the company profitable during the period in question?
Solvency: Can the company meet its long-term debt obligations?
Activity: Is the company efficiently managing its assets and other resources?
Ratio analysis expresses the answers to these questions in the form of measures derived from a company's income statement, balance sheet, and statement of cash flows over a defined period of time. Think of it as a sort of shorthand that can give you information on a company's progress at a glance. Once you get used to using a handful of important ratios, you can perform a checkup on each of your portfolio holdings once a quarter, when publicly traded companies update their financial results, and issue financial statements. This series looks at each of the four areas; for the remainder of this article, we'll examine the topic of liquidity.
Cash is king when the time frame is one year or less
Liquidity is simply a company's ability to pay its current bills and short-term debt obligations with the resources on hand. For these purposes, short-term means a time frame of less than one year. Working capital, the difference between a company's current assets and current liabilities, is an important concept in liquidity. If you take the two components of working capital, and simply divide current assets by current liabilities, you get a result known as the current ratio.
A current ratio above 1.0 indicates that a corporation has enough current assets on hand (cash, receivables, inventory, etc.), to meet its current obligations (accounts payable, short-term debt, taxes payable, and the like). A current ratio below 1.0 should be investigated, and a current ratio below 1.0, quarter after quarter, constitutes a red flag. By the same token, a current ratio that is too far above 1.0 on a consistent basis (say 2.0 or above) should also be probed, as it may imply that a company is not investing its excess cash -- an inefficient use of resources.
The current ratio can quickly point you to important further inquiry. For an example, let's look at this ratio as calculated for three well-known corporations: Apple (NASDAQ: AAPL ) , Tesla (NASDAQ: TSLA ) , and salesforce.com (NYSE: CRM ) :
Apple, as you would expect, has a fairly healthy current ratio. You may wonder why, given the amount of press devoted to Apple's "cash hoard," the current ratio isn't higher than it is. After all, aren't activist shareholders pushing the company to either utilize its cash, or return it to shareholders? The discrepancy is generated because Apple keeps about $104 billion invested in long-term marketable securities, and those funds aren't counted as current assets. Notice the declining trend of the current ratio over the last few years. Don't let this fool you. Apple generates so much cash that it can more or less manage its current ratio as it sees fit. In this case, the downward trend is good, as it indicates that Apple is effectively using its excess greenbacks.
Does Tesla's current ratio make sense?
Tesla's current ratio also leads to inquiry. If the company is sustaining losses as it grows its production capabilities, how does it have such a comfortable margin when addressing current liabilities?
The answer can be found on the company's statement of cash flows: Tesla conducted stock and debt offerings in the quarter ended June 30th, 2013, to boost its cash on hand, and pay down existing debt. If you're interested in owning shares of Tesla, understanding where its resources come from can help you decide when and how to invest. Eventually, cash flows generated from profit should replace the cash that has been raised now in order to help the company grow comfortably. So, while the healthy current ratio isn't really due to sustained profits today, it does seem to derive from sensible management of a rapidly growing company's immediate needs.
Salesforce.com: Where is the ready money?
Salesforce.com presents a different matter entirely. The fast-growing cloud-computing company seems, at first glance, to have a liquidity problem. A current ratio of 0.55 means that the company has about half the resources it needs at hand to meet current obligations. If you see a current ratio in this range when scanning a stock's key statistics on Fool.com or Yahoo! Finance, this is your cue to look at the financials, and try to get a sense of what's going on.
Reviewing the company's recent financials, some might argue that the current ratio of salesforce.com is skewed, as the company carries a large deferred revenue balance relative to other items on the balance sheet. Deferred revenue, a liability, is comprised of the cash and receivables a company claims on its books for services not yet rendered. In this case, deferred revenue is equivalent to subscription revenues for salesforce.com's popular applications.
Yet, it's fair to say that salesforce.com suffers from poor liquidity. It essentially uses cash to operate that is already spoken for, and could theoretically be reclaimed by customers. You can read more about salesforce.com's liquidity issues here, but the point is that the very low current ratio is a call to more investigation if you own salesforce.com, and are conducting a quarterly review of your holdings.
There are other related liquidity ratios which promote an even stricter definition of liquidity, such as the "Quick Ratio," which excludes assets like inventory, which take time to convert to cash, or the "Cash Ratio," which pits only a company's cash against its current liabilities. These are useful to know, but for starters, you can review a holding's current ratio, and its trend lines, as a first blush at determining relative health. This liberating, once-a-quarter exercise can help free you from the noise of the daily news cycle and, hopefully, will inject a reasonable degree of certainty into your investing strategy.
Do you want to put your financial ratio smarts to good use?
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