Investing 101

Liquidity focuses on a company’s ability to meet its short term obligations and this varies by industry. Investors prefer companies with high liquidity ratios but larger companies can get away with lower liquidity ratios because of greater funding sources, compared to smaller companies. During the peak of the pandemic, the US federal government pumped liquidity into the economy with interest-free loans to institutions and stimulus payments to individuals.

Current Ratio = Current Assets/Current Liabilities

A higher ratio is preferred because it indicates a company has liquidity, more capacity to take on debt and meet its short-term obligations.

Another helpful measure is the cash conversion cycle, which calculates the number of days it takes for a company to collect cash. Operations with a lower cash conversion cycle will have greater cash on hand and hence liquidity.

The defensive interval ratio measures how long a company can pay its daily cash expenditures with only existing liquid assets (no additional cash flows).

Defensive Interval Ratio = Cash + Short Term Marketable Securities + Receivables Daily Cash Expenditures

During the peak of the pandemic, the FED pumped liquidity into the economy with interest-free loans to institutions and stimulus payments to individuals.

Liquidity

Fundamental Valuation Ratios

Solvency ratios focus on a company’s ability to meet its long term obligations such as debt. The amount and type of debt a company holds will influence their future risk and return. This measure is known as leverage and there are 2 kinds. Operating leverage comes from fixed costs like building rent and financial leverage arises from financing costs like interest expenses.

A commonly used measure is the debt-capital ratio which measures what percentage of a company’s total capital is financed by debt.

Debt-to-Capital Ratio = Total DebtTotal Debt + Shareholder's Equity

On the financial leverage side, the interest coverage ratio (aka Times Earned Ratio) represents how many times earnings before interest and taxes (EBIT) can cover the interest payments.

Interest Coverage = EBIT/Interest Payment