We've managed to plow our way through the entire balance sheet, defining and examining each element as it appears. It's been a long journey and now comes the reward: Math! There are a few formulaic tools we can use to assess a company's strength in asset management and measure its power of liquidity.
First up, the Current Ratio is a measure of a company's ability to use its current assets to pay off its current liabilities. It's simply the current assets divided by current liabilities. For instance, that hip dance club Fischer's Fandango Fortress has current assets of $25 million and $17 million in current liabilities, it's current ratio would be:
$25 million Current Ratio = ------------- = 1.47 $17 million
Not bad, but it's about the cutoff of where we'd normally like to see it. Generally speaking, a current ratio of 1.5 or higher is reasonably sufficient to meet operational needs. Naturally, the higher the ratio, the greater the financial strength of the company. However, too high a current ratio may suggest that the company isn't optimizing its use of current assets to run and grow its business.
Look at the trend of the current ratio from quarter to quarter to determine if its financial position is maintaining or declining. It's also important to look at the ratios of the company's peers within an industry. Some sectors will have comparatively lower or higher norms than others.
The Quick Ratio is also a measure of a company's ability to cover its short-term liabilities. This ratio, however, is particularly focused on the liquidity of current assets. Since inventories are not always readily salable and are often sold at a deep discount to the amount recorded on the balance sheet, the quick ratio eliminates inventories from the equation. To determine a company's quick ratio, take current assets minus inventories, divided by current liabilities.
If we look back at Fischer's Fandango Fortress, we notice that a large percentage of its current assets are in the form of Citrus Zima, which has been piling up in the basement. We'll remove the snappy citrus beverage and other inventories from current assets in order to determine the quick ratio:
(Current Assets - Inventories) Quick Ratio = ------------------------------ = Current Liabilities $25 mm - $10 mm = -------------------------- = 0.88 $17 mm
Fischer's may not be as ready to meet cash demands as we previously thought. We generally want to see a quick ratio of 1.0 or higher, indicating that a company has enough relatively liquid assets to pay off its current liabilities. Our lively Spanish dance club could run into trouble as it's forced to sell Zima for pennies a bottle and doesn't have enough liquid assets to pay the bills.
As with the current ratio (and pretty much any ratio), you'll want to compare the quick ratio with those of industry peers and also focus on its trend over time.
The final measure of liquidity is what is known as Working Capital. This is the fuel in the gastank of a company; what makes it zoom down the autobahn. Working capital is simply current assets minus current liabilities. This is the net amount the company has to funds its operations and provide growth.
Working capital is essential for the success of any business. If a company has abundant working capital, it has the ability to pay for everything it needs to and then some. If, however, its working capital is negative, it will lack the ability to spend as it desires, as well as meet obligations.
An interesting measure of value is a company's current working capital relative to its market capitalization. If you divide working capital by market capitalization, you can determine how much of the company is actually backed by working capital. Let's look at the working capital of Fischer's Fandango Fortress:
Current Assets - Current Liabilities = Working Capital $25 mm - $17 mm = $8 mm
Now, if we divide that by Fischer's market cap of $20 million, we get a working capital to market cap. ratio of 0.4 (8 / 20 = 0.4). 40% of the dance club's market capitalization is backed by working capital. Not terrible, but it could be better. Ratios of 50% or higher indicate a company that's in pretty good shape. Compare Fischer's to other dance clubs and see if it has more or less cash backing up its operations than its peers.
These are three useful tools to use when examining a company and comparing it with its peers. Keep those nuclear-powered calculators handy, as next week we'll look at a few more and close out the series on the balance sheet.
Drip on, Fools!