Investing For Beginners

Investing For Beginners is a series of articles, resources, and other information about basic investments, value investing, quantitative research and other ideas.

Financial Ratios: How to Determine Solvency

Before putting money into a stock investment, you should analyze the company's financial solvency using the following financial ratios which determine whether a company has enough cash, assets and credit to continue operations without running into financial trouble.  These solvency ratios are quick calculate and easy to interpret.


A solvent company is one that owns more than it owes; in other words, it has a positive net worth and a manageable debt load.  Liquidity refers to a company’s ability to pay short-term obligations; the term also refers to its capability to sell assets quickly to raise cash. 

Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity. A number of financial ratios are used to measure a company’s solvency and liquidity, the most common of which are listed below.

Current Ratio

This financial ratio is used to determine the company’s ability to pay back its short term liabilities.  A low ratio doesn't mean the company will go bankrupt, but is something that needs further examination.

Current Ratio = Current Assets / Current Liabilities

If the ratio is below 1, it raises a warning sign as to whether the company is able to pay its short term obligations when due. Note that a company may have a low current ratio but could be a characteristic of the industry. 

Quick Ratio

This financial ratio, also known as the "Acid Test Ratio" is similar to the current ratio except that inventory, supplies, and prepaid expenses are not included.

Quick Ratio =  (Current Assets – Inventories) / Current Liabilities

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.

Debt/Equity Ratio

There are variations of debt/equity ratio, but the objective of these financial ratios is similar:  to determine how a company has been financing its growth.

Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity

A high ratio means that the company has been growing due to debt. Not all debt is bad, but if the number is exceedingly high, remember that the company has to pay off the loan as well as interest payments.

Summary

These financial ratios are easy to calculate and easy to interpret.  They inputs to the ratio formulas are located on the company balance sheet.  Be certain to compare the company ratios to the industry average before making any final decisions whether or not to invest.

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