W. Kandinsky, Noeud Rouge, 1936

Investment School

Ratios

Ratios

Current Ratio

A measure of how much liquidity a company has, this is simply the current assets divided by the current liabilities. As a general rule, a current ratio of 1.5 or greater is normally sufficient to meet near-term operating needs. A current ratio that is too high can suggest that a company is hoarding assets instead of using them to grow the business -- not the worst thing in the world, but potentially something that could impact long-term returns. You should always check a company's current ratio (as well as any other ratio) against its main competitors in a given industry. Certain industries have their own norms as far as which current ratios make sense and which do not.

Quick Ratio

Current assets minus inventories divided by current liabilities. By taking inventories out of the equation, you can check and see if a company has sufficient liquid assets to meet short-term operating needs. Most people look for a quick ratio in excess of 1.0 to ensure that there is enough cash on hand to pay the bills and keep on going. The quick ratio can also vary by industry. As with the current ratio, it always pays to compare this ratio to that of peers in the same industry in order to understand what it means in context.

Price/Sales Ratio

Cash Ratio

The amount of cash (more formal name is Net cash provided by operating activities) that a company has divided by its current liabilities. It is just another method to compare various companies in the same industry with each other in order to figure out which one is better funded. In the best case the ratio should be significantly larger than the corresponding net income figure.

Flow Ratio

Flow Ratio = (Current Assets - Cash) / (Current Liabilities - Short-term Debt). the numerator -- current assets minus all cash and equivalents(marketable securities and short-term investments) -- represents a company's investment in inventory, accounts receivable, and prepaid expenses. These are items that the company has already paid for, and now they're just sitting around and waiting to be converted into cash at a future date.

The denominator: Current liabilities are essentially a company's interest-free IOUs. In other words, these monies represent goods and services which the company has already purchased and received but hasn't yet paid for. The only "bad" type of current liability is short-term debt because it carries interest charges. Thus, we subtract short-term debt from the current liability total

With the Flow Ratio, it's best to see as low a numerator as possible, and we like to see the denominator as high as possible. All in all, we're generally looking for Flow Ratios below 1.25 -- and the lower the better.

Parameters

Working Capital

Working capital is simply current assets minus current liabilities and can be positive or negative. Working capital is basically an expression of how much in liquid assets the company currently has to build its business, fund its growth, and produce shareholder value. If a company has ample positive working capital, then it is in good shape, with plenty of cash on hand to pay for everything it might need to buy. If a company has negative working capital, then its current liabilities are actually greater than their current assets, so the company lacks the ability to spend with the same aggressive nature as a working capital positive peer. All other things being equal, a company with positive working capital will always outperform a company with negative working capital.

Market Capitalization

Market capitalization is the value of all the shares of stock currently outstanding plus any long-term debt or preferred shares that the company has issued. The reason you add long-term debt and preferred shares (which are a special form of debt) to the market capitalization is because if you were to buy the company, not only would you have to pay the current market price but you would also have to incur the responsibility for the debt as well.

If you take a company's working capital and measure it against a company's market capitalization, you can find some pretty cool stuff. You can compare working capital to market capitalization by dividing working capital by that market capitalization.

Gross Margin

Gross margins are defined as the gross profits (sales minus cost of goods sold) for a period divided by the revenues for the same period. Look for the number bigger than 50%.