When you are looking to invest in individual stocks, it makes sense to look at the company’s financial statements (or at least the company profiles on Yahoo! Finance and Morningstar). This series “Looking at Company Financial Statements and Ratios” tries to break down some of the things you should look at to help understand how the company is doing and whether it is priced fairly. Last week, we covered the Operating Cash Flow and Free Cash Flow, looking at the amount of cash generated by core business activity. This week, we’re going to switch over to the balance sheet and look at liquidity: how well can a company cover the obligations it needs to pay in the upcoming year.
A quick balance sheet review: Balance sheets are split into Assets, Liabilities and Equity. The basic balance sheet equation is assets must equal liabilities plus equity, but what that actually means is that your assets (your company’s resources) minus your liabilities (what your company owes) equals your equity (the value of the company). Assets and liabilities are generally split into current and long-term. Current assets will be used within the year (cash, accounts receivable, inventory), while long term assets will be used over a longer period of time (plant, property & equipment, investments). Likewise, current liabilities will be due in less than a year (accounts payable, accrued expenses, current portion of debt) while long-term liabilities are due in more than a year (long term debt, pension obligations).
Liquidity examines how easily a company can absorb current liabilities with current assets. Low liquidity means that the company has cash flow problems and will have to raise capital to cover regular expenses by selling off long term assets, refinancing debt (probably at higher interest rates) or selling more shares of stock. Low liquidity is a problem that as an investor should make you wary.
The first thing to look at when examining liquidity is Net Working Capital, which is fairly easy to ascertain: Current Assets minus Current Liabilities. If current assets are more than current liabilities, then a company has positive working capital. If current liabilities are larger, then the company has negative working capital. The degree of positivity or negativity is measured by the Current Ratio (also known as the Working Capital Ratio), which is current assets divided by current liabilities. A company with a current ratio of 1 has current assets equal to current liabilities. A current ratio of less than 1 means that the company has more short-term obligations than it has short-term resources to cover them. A ratio over 1 is better.
The issue with the current ratio is that not all current assets are equally liquid. Marketable securities, and most accounts receivable can easily be converted to cash to cover their immediate obligations. Inventory, however, can be more problematic to convert to cash, particularly if the economy slows down or the company miscalculated demand for its products. Prepaid expenses are just credit for bills you know you are going to get but haven’t gotten yet. The Quick Ratio gives a more conservative look at a company’s liquidity. To get to the Quick Ratio (also known as the Acid Test Ratio), you take higher liquidity current assets like cash, marketable securities, and current receivables and divide by all current liabilities. Alternately, you can take all current assets and subtract out inventory, restricted assets, and current prepaid expenses (sometimes just inventory, depending on the statement and the person calculating) before dividing by the current liabilities.In this case, I’ve used the first method of (cash + marketable securities +current receivables)/current liabilities.
Let’s take a look at the financial statements from 2008-14 for General Motors. I’ve picked GM because the automobile industry is capital intensive, which means GM is going to carry a lot of long-term assets and liabilities. It’s a well-established company with a long history, but was losing so much money at the beginning of the Great Recession that it declared bankruptcy in 2009 and the US federal government had to step in with billions of dollars. So using GM’s balance sheets gives us the ratios of a company having serious liquidity problems as well as a company on more solid footing. (A word on the 2010 financials: Before 2010, GM’s figures did not include GM financials. In 2010, they did, but GM Financial’s assets and liabilities were not split into Current and NonCurrent. Through the notes to the financial statements, I’ve managed to allocate the amount of cash, current receivables and current debt GM Financial held.)
At the end of 2008, you can clearly see GM is in trouble with negative working capital of $31 billion. Their current ratio is .59 and their quick ratio is at a dismal .29. So they only had enough liquid assets to cover 29% of the liabilities that were due in 2009. This is why GM was filing bankruptcy, the largest corporate bankruptcy in US history. In 2009, however, after bankruptcy restructuring and the influx of government funds, GM’s liquidity looked much better. Working capital was positive, at $6.8 billion, the current ratio had reached 1.13 and the quick ratio is at .58. Numbers are not great, but they are clearly improving. By the end of 2010, though total working capital has actually decreased, the current ratio was at the same year and the quick ratio had increased to .78. Since 2010, GM has increased their working capital and current ratio and maintained their quick ratio.
Liquidity ratios should be examined in relation to industry standards and competitors, and over time. Some industries have far more emphasis on current assets and liabilities than others. Companies can influence their liquidity ratios by how they classify assets and liabilities as current and noncurrent, and a careful investor will examine the notes to the financials to determine if assets or liabilities need to be shifted from noncurrent to current before liquidity and debt ratios are calculated.
Why should you care?
The main people who check liquidity ratios are the ones who work for companies that lend money and extend credit. When lending money, companies want to make sure that the company borrowing from them has capacity to pay them back. But it’s a very good tool for investors as well, as it can point out red flags. A company that cannot pay its bills is rarely a good investment. It will not be able to pay dividends, increase its value through reinvestment or retain its stock value.
This article is for information purposes only. GM was picked to illustrate liquidity ratios, but there is no recommendation of the company’s stock was intended. Past performance does not determine future performance, and an investor interested in any company’s stock should proceed with caution and do lots of research before putting their money in any investment.
References and Further Reading:
The Current Ratio & Quick Ratio Formula | Acid Ratio | Liquidity Ratio –from MyAccountingTools.com
Liquidity Ratios-from MyAccountingCourse.com