Understanding a company’s financial health is a key component in investment decisions, a business with strong balance sheet stands a higher chance of surviving economic crisis, changes in economic climate or business cycles. Here are some simple ratios for you to apply to avoid companies with excessive leverage.
Quick Ratio = (Current Assets- Inventories)/Current Liabilities
A measure for short term liquidity, quick ratio gives you an idea of how much liquid assets are available to be utilize in the event of credit emergency. Dealing with inventories can be complicated as each business carries different types of inventories, obviously some are easier to liquidate than others, hence we exclude inventories from this calculation.
Current Ratio = (Current Assets/Current Liabilities)
This formula is often confused with the quick ratio, but it is in fact very different, current ratio is used to determine the ability of a business to meet its short and mid term obligations. The current ratio is express as a multiple, where a higher ratio suggest that the business has enough liquid and illiquid(inventories) assets to meet its obligations.
Interest Coverage Ratio
Interest Coverage Ratio = (EBIT/Interest Expenses)
This is very useful to determine if the business is capable of managing its payments on loans, you can also compare the amount of interest they are paying versus their revenue or operating income.
Debt to Equity
Long term debt to Total Equity = Long term debt/Total Equity
This ratio tells us how much leverage a business uses to finance its assets, typically businesses in the real estate sector tend to have higher LT Debt to Equity than other sectors. You can apply this formula to avoid real estate companies that are abusing leverage in an attempt to prop up growth.
Total Debt to Equity = Total Debt (Current Liabilities + Long term debt)/Total Equity
This is a slightly conservative formula compared to LT Debt to Equity as it considers all forms of debt.
Long Term Debt to EBITDA/EBIT
Long Term Debt to EBITDA/EBIT = Long Term Debt / (EBITDA/EBIT)
LT Debt to EBITDA is a measure of company’s ability to pay off long term obligations, it is a gauge of the amount of time the company requires to pay off long term debt. Growth companies may not hold onto large amount of cash reserves in the balance sheet, these companies prefer to invest in expansion to generate more cash flow. Hence this will be a better measurement.
Include these formulas in your investment framework to avoid companies that are taking on excessive leverage, you can also use these formulas as a primary criteria to screen out stocks that are in a strong financial position. Good Luck!