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Wednesday, August 11, 2010

Look at Debt while Evaluating Stocks

When the economy is in trouble, you may want to pay more attention to debt when evaluating a stock for investment. Companies that a carry heavy debt load may be at risk in a difficult economy.

There are several measurements you can use to gauge whether a company may be carrying too much debt. Both come off the balance sheet if you want to do the math yourself or you can find the ratios on several online services.

The two ratios are part of a set of metrics that help you determine the financial health of a company when you are evaluating its stock for investment. Below are the two definitions before we move on:


• Current Liabilities are bills that will come due in the next 12 months. These include the company’s normal operating expenses such as salaries, utilities, and so on. Long-tern debt, such as mortgages would not be included, however that portion of payments due in the next 12 months would be included.

• Current Assets are marketable securities, cash and other assets that can be easily converted to cash within 12 months. Land and real estate do not fall into this category because it often takes longer than a year to sell property.

The first ratio is the Quick Ratio. This ratio gives you an idea how easily the company can pay its current obligations – that is those bills due in the next 12 months.

Quick Ratio

The Quick Ratio is cash, marketable securities and accounts receivable divided by current liabilities (those due in the next 12 months). However, not all Current Assets are included in this ratio - excluded are accounts receivable and inventory. Basically, you are saying if all income stopped tomorrow and the company sold off its readily convertible assets, could it meet its current obligations?

A Quick Ratio of 1.00 means the company has just enough current assets to cover current obligations. Something higher than 1.00 indicates there are more current assets than current obligations.

It is important to compare companies with others in the same sector because different industries operate with ratios that may vary from one sector to another. Some industries such as utilities, for example carry much more debt than other industries and should only be compared to other utilities.

Current Ratio

The second ratio is the Current Ratio. The Current Ratio is very similar to the Quick Ratio, but broadens the comparison to include all Current Liabilities and all Current Assets. It measures the same financial strength as the Quick Ratio that is a company’s ability to meet its short-term obligations.

Some analysts like the Current Ratio better because it is more “real world” in that a company would convert every available asset to stay afloat if needed. The Current Ratio measures that better than the Quick Ratio.

Like the Quick Ratio, 1.00 or better is good, and likewise you should always compare companies in the same sector.

Theses two ratios, which you can find on most of the financial web site that offer quotes, tell you a great deal, about how a company may or may not weather tough times. Low numbers in these ratios should be a red flag when you are evaluating a stock.