In this post we will try to learn how we can ensure that the money we are going to invest in a company doesn’t go down the drain. Essentially, we will try to evaluate the intrinsic financial soundness of the company and understand the financial ratios or filters that we need to apply to remove risky companies from our consideration set.
Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.
Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.
Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.
Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.
Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.
While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.
Saturday, February 14, 2009
Subscribe to:
Post Comments (Atom)
Posts
I like sticking with stocks in stable sectors some utilities food stocks healthcare stocks consumer staples stocks. When a company sells a product or service that everyone needs on a regular basis this takes some of the risk out of the stock because although no one can predict for certain how much demand their will be for a companies products or services. We know that tissue will always sell regardless of what happens to the economy.
ReplyDelete