Financial Ratio Analysis (Liquidity ratios and leverage ratios)

Liquidity ratios are about how solvent a firm’s assets can be. Naively put: If the firm is trouble, eg. Short of cash, how quickly can they sell their assets and get cash to get by. There are current ratio, quick ratio (main difference here is there is no inventory for quick ratio). Account payable is a good measure too since if you can postpone your payment to others you have more flexibility. I remember when I looked at Palm’s AP turnover I did see the change as the firm started to get stressed. You know, when a firm is in good shape, the suppliers won’t be too eager to collect their money as long as within reasonable time frame. However, when a firm is in stress, everybody want their money back as soon as possible. (same concept as a bank run, I assume) Some of the liquidity ratios are as follows:

Current ratio                             Current assets / current liabilities

Quick ratio                                (Cash + short-term investments + A/R) / current liabilities

Interest coverage ratio              (Net income + tax expense + interest expense) / interest expense

A/P turnover (times)                 Cost of good sold / average accounts payable

Leverage Ratios represent how the management utilizes capital. I always have trouble reading company’s report saying they’re raising equity while there almost no debt on the balance sheet. Small chinese companies tends to do. Don’t invest on them. Trading them can be dangerous too. Of course we all know, debt level needs to be  balanced. Many issues need to be considered: tax shield, interest coverage, etc. Two important leverage ratios are as follows:

Capital structure leverage       Average total assets / average shareholders’ equity

Long-term debt ratio               Long-term liabilities / total assets

Amazon as the example: liquidity ratios---

It’s interesting to see there is a dip for current ratio in 12/31/09 quarter. Can you guess why? Remember when I discussed the efficiency ratios, Amazon had a great quarter on 12/31/09 and its sales turnover is great and inventory turnover as well. That’s why: not much inventory left. You see, this is how the whole financial analysis framework keeps its integrity.

Leverage’s power can be easily seen from ROE vs ROA. We can simply assume ROE=ROA*Capital structure leverage. So, Amazon has 2 times asset to equity then ROE is two times of ROA. That simple.

Alright, now we should have gone over all the key ratios and let’s look at the framework once again as a whole. Again, it’s like an X-ray for a firm. When you evaluate a company you have to look at all perspectives and ratio analysis is the easiest way to dissect information. After you analyze one company you can compare with its peers eventually; then you might be able to say you have a good feeling about your company if data speaks good things about it.

Note: good financial ratios and trends don't warrant higher stock price since the market might have price in  all the future growth. Although, it does may you feel comfortable when investing a stock with sound fundamentals. In addition, if you are patient enough to get in a good stock with enough "margin of safety" it would be better.

People always wondering what is a stock really worth. Great question but a really hard one to answer. Don't just listen to others for price target since different people might have different trading/investing time frame. I do try to valuate company interested me and I encourage you do your own. However, treat it as an art project rather science one. Challenge your assumptions as new information arrives all the time.

On the other hand, ratio analysis is sort of science project as numbers reveal great informations. You still need to incorporate financial statements, news, research reports, etc to understand the ratios better and make reasonable projections. Well, with some basic accounting intuition financial ratio analysis can really help you diagnosis your company's health. This post concludes the introductory series. Hope it makes sense.