Company balance sheets show the long-term financial health of the company, if investors know where to look. The current ratio is a measure of liquidity that lets investors know if a company can or cannot pay back its liabilities using its current assets.

In this clip, Motley Fool healthcare specialists Kristine Harjes and Todd Campbell share the formula for the ratio, how to calculate it, and how to translate the number into practical investment information by using real-world examples from the healthcare sector.

A full transcript follows the video.

 

Kristine Harjes: So, we figured it would be helpful to talk about some specific companies, just to get a sense of how you would compare a balance sheet between several different companies. So, the two that we wanted to highlight were Pfizer (NYSE:PFE) and Bristol-Myers Squibb (NYSE:BMY), which you'll hear us refer to as Bristol, BMY, easier than saying the whole thing. The common thread between these two companies is that they're partners on a next-generation blood thinner called Eliquis. Eliquis was approved in late 2012, and has had kind of a slow ramp-up, but it's doing really well now. Last quarter alone, there was $466 million in sales for Eliquis.

Todd Campbell: You look at drugs that are growing very quickly, it's very hard for blockbuster drugs, billion-dollar drugs, to keep growing fast, because obviously, they're being used with more and more patients. But Eliquis is a very interesting drug, because Warfarin has been used as the mainline anticoagulant for patients for 50 years. And now, Eliquis, which is a factor Xa inhibitor, works very differently, is starting to really eat into that market share. Sales have doubled in the last year.

So, you look at it, you say, "OK, we've got a company where sales are more than doubling on a drug. Which of these two companies -- they split profit on this drug equally -- might be the better investment, if I want to have exposure to this drug?" One of the ways you can help determine that is by looking at the financial health of the company, which we've already established involves checking out the balance sheet.

Harjes: Exactly. With that, let's dig right in. One of the metrics that I like to look at when I'm considering a balance sheet is called the current ratio. The current ratio basically tells you whether or not a company can pay back its short-term liabilities using its short-term assets. How exactly is this calculated?

Campbell: This is a quick and dirty, great ratio for investors to look at, just to say, "OK, if creditors come knocking, how likely is it that the company is going to be able to pay them?" So, it's like a measure of liquidity. It tells you whether or not a company is likely, a year from now or within this year, to remain solvent. If you have a current ratio that is below one, you should be nervous. If you have a current ratio above one, it's OK.

Harjes: Of course, and you can tell that just from looking at the actual calculation of assets divided by current liabilities, that one is really your benchmark there of, can you meet these obligations with current liquidity?

Campbell: Right. Again, investors don't have to do this calculation on their own, unless they want to. Plenty of websites that are free online will provide this to you under "key statistics" or some other area of their website.

Harjes: And so, when you look at the two companies we've been talking about, Pfizer has a current ratio of 1.61, which sounds pretty good, it's above one. But then, you look at Bristol, and they are posting 1.81. So, advantage Bristol there.

Campbell: Yeah, advantage to Bristol on this measure. But it is important to note that both of these companies look good on this measure. Again, above one means there's no short-term risk to them being able to handle their obligations. On the other side, because you may run into this as an investor, when you're considering healthcare stocks, if you end up with a current ratio that's too high, that could be a sign that they're having a hard time figuring out what to do with their money. And they're not re-investing that money in something that's going to provide net income growth down the line. So, you almost want to have a Goldilocks kind of current ratio. And I usually define that as between one and three. So, both of these companies are fine, at 1.61, 1.62 for Pfizer and 1.81 for Bristol, but we'll give the edge to Bristol on this one.

Kristine Harjes has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.