I love it when stocks fall. I love it even more if the stocks that fall aren't the ones I already own.
In times like our current one, you can find lots of bargains -- great companies trading at good prices or average companies trading at dirt-cheap prices. The great companies tend to be the easier and safer investments. Dell (NASDAQ:DELL) and Bristol-Myers Squibb (NYSE:BMY) may have been struggling recently, but they're extremely unlikely to go bankrupt. So if you make a mistake with these companies now, when there prices are already so depressed, it probably won't cost you that much.
But when you start looking at the next tier of companies, the scenarios aren't so clear-cut. Such companies often become much cheaper than blue chips because they're less prepared to deal with adversity. These businesses have a significant chance of bankruptcy during a crisis. So if you want to go investing in these troubled waters, you should play close attention to liquidity.
Liquidity: More than just a drink
Liquidity is the extent to which a business has the cash to pay its obligations. It's important because if a company can't pay its bills, it goes bankrupt -- usually wiping out common shareholders' investments in the process.
Though shareholders tend to focus on earnings, when looking at liquidity, income can be deceiving. A company can be profitable but still go bankrupt if it doesn't have enough cash. To really understand a company's liquidity position, examine the balance sheet and cash flow statement.
One of the most useful balance sheet ratios for understanding liquidity is the quick ratio:
Quick Ratio = (Current Assets - Inventories) / Current Liabilities
The idea is that the company will have to pay off its short-term obligations no matter what. If it doesn't have enough current assets to do so (i.e., its quick ratio is less than 1), it's going to have to find cash somewhere else -- perhaps by borrowing money or issuing shares. You generally want the quick ratio to be greater than 1 -- and the larger, the better.
Inventories are excluded from the quick ratio because the fair-market value of inventories may not be what is listed on the balance sheet and because if the business is to remain a going concern, it will need to maintain a reasonable level of inventories.
Follow the cash
The other key source of liquidity information is the cash flow statement. Income is nice, but the cash flow statement can really show how much cash is actually entering the company's coffers. Take, for example, First Marblehead (NYSE:FMD), which provides outsourcing services for student-loan providers. It earns upfront fees, but it also receives residual income years later based on the performance of the loans it sells. As you'd expect, this residual income immediately shows up on its income statement because it's worth something. But it's not yet on the cash flow statement because residuals aren't cash -- and they won't be for years. Other companies, such as H&R Block (NYSE:HRB) and General Electric (NYSE:GE), have similar discrepancies between the income and cash flow statements.
When looking at the cash flow statement, your goal is to determine how much cash the company is actually making on a recurring basis and whether this cash flow is sufficient to meet its obligations. As such, you should pay particular attention to cash from operations, modified to take into account one-time items.
For instance, last year, Overstock.com (NASDAQ:OSTK) had $15.6 million in depreciation and $44.7 million in capital expenditures -- both numbers significantly higher than previous years. When estimating the cash that Overstock is actually using on a recurring basis, I'd subtract a number greater than its depreciation, since Overstock's capital expenditures are generally more than it writes off to depreciation. But I wouldn't consider the $44.7 million number to be recurring, since Overstock made a significant (and likely one-time) upgrade to its infrastructure last year.
Fear of Chihuahuas
Even if the balance sheet and the cash flow statements look fine, if a company has debt, it can be torpedoed by its creditors when that debt comes due. Your friendly corporate banker may seem a jolly fellow, but he's as skittish as a squirrel. The second he sees anything no scarier than a Chihuahua, he's inclined to flee up the nearest tree.
Thus, if you're investing in an out-of-favor industry, be very aware of debt maturities. If a large chunk of debt is due soon and during bad times, the company may have difficulty rolling that debt over, even if its cash flow seems sufficient to service that debt.
Why bother?
Understanding liquidity may seem like a lot of work, but it can be worth it. If you do find a company that the market unfairly punishes because of short-term factors, you can quickly hit a multibagger when the market regains its senses. Just look at Monsanto's (NYSE:MON) returns since 2003, when bad weather, uncollectible receivables, and a lawsuit stoked the market's fears. It's been one of the best-performing stocks in the S&P 500 since then.
As an alternative, there is a shortcut. Our Inside Value newsletter has handily beaten the market because of its success in identifying these sorts of opportunities. You can check it out with a free, 30-day guest pass.
Fool contributor Richard Gibbons is more skittish than a banker. He owns shares of H&R Block, First Marblehead, and Overstock.com, which is a former Rule Breakers pick. Dell is a current Inside Value and Stock Advisor recommendation, and First Marblehead is a Motley Fool Hidden Gems pick. The Fool has a disclosure policy.
