To keep afloat, a company must meet its short-term liabilities.
Debt is big news these days, and a good few companies are having trouble with liquidity. So whenever a company announces its results, we really should have a close look at its debt situation. It isn't always immediately obvious whether a particular level of debt is especially bad, and it doesn't really matter very much if a company owes a lot as long as it is making sufficient profits from the borrowed money. In fact, financing a company's operations through debt can be a very profitable strategy.
So how can we tell if a company might be facing liquidity problems?
Today we'll take a look at three measures that can help us find out -- Interest Cover, the Current Ratio, and the Quick Ratio. Some paid-for data services will give you these ready-made, but we'll do it the cheap way and look at some accounts to see how to calculate them.
I'll use Indigo Vision (LSE: IND) and its 2009 annual report, which you can get from the company web site -- I like this report, because it is very simply and clearly presented.
If a company can't meet its interest payments, it's in serious trouble, because banks and other lenders have a tendency to foreclose if nothing is done about it pretty quickly. Interest Cover is a measure of how easily a company's earnings are covering its interest payments.
It's defined quite simply, and we calculate it by dividing a company's earnings before interest and tax (EBIT) figure for an accounting period, by the interest paid in the same period.
It is generally considered that an interest cover of at least 2 is a good idea, but if earnings are volatile, we should probably look for something higher to avoid a squeeze in a low year. The tricky thing is that EBIT isn't usually stated in a company's accounts, so we have to work it out.
If we look at Indigo Vision's Income Statement on page 12 (printed page 12, PDF page 14), what we need to do is take the "Profit before tax" figure, of £3,263,000 (which has already had interest deducted) and add back the interest paid to obtain the EBIT figure. We can see that financial expenses came to a lowly £1,000, and note 5 tells us that that was all interest. So, working in thousands…
Interest Cover = (3,263 + 1) / 1 = 3,264.
Indigo Vision could have paid its interest 3,264 times over, and obviously there is no problem there.
For our next measure, we need to turn to the balance sheet, on page 14. Remember that current assets comprise cash itself and assets that are expected to be turned into cash (or equivalents) within the next 12 months, and that current liabilities are payments that will become due within the next 12 months.
A good measure of short-term liquidity, then, is to compare the two, and the Current Ratio does just that, by dividing total current assets by total current liabilities. For Indigo Vision we get…
Current Ratio = 12,602 / 3,215 = 3.9
That means that Indigo Vision should be able to meet all of its next 12 months of liabilities nearly 4 times over from cash expected during the period, so it looks like there is going to be no problem meeting its obligations over the next year.
But what if a company was called upon to settle all its current liabilities with very short notice? Would it have the assets to do it? That's the question that the Quick Ratio (which is sometimes referred to as the "Acid Test") seeks to answer.
What we need to do is decide how much if its current assets a company could quickly convert to cash, and the usual way to do that is to take the total current assets figure and subtract inventories. Cash equivalents, which include things like liquid investments such as shares, can be converted quickly, and accounts receivable -- money owed for goods and services already supplied -- are usually settled within not many weeks. But inventories are goods that have already been produced but not yet sold, and so they can't be counted.
Calculating from Indigo Vision's balance sheet…
Quick Ratio = (12,602 – 2,909) / 3,215 = 3.0
So Indigo Vision could meet all of its 12-month liabilities almost immediately, without selling another thing.
So that's good then
Clearly, Indigo Vision is a company with no debt or liquidity problems whatsoever, which many would see as an enviable position to be in.
But what about other companies? If you have any favourites of your own, why not get hold of a copy of the latest annual report, have a go at working out these measures for yourself, and then posting your results as a comment below?
And if you have any problems or need any help, just point me at the report and I'll have a go at it myself.
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