Liquidity Ratios Every Fundamental Investor Should Know
Stock prices are impacted by many different factors, so investors need to thoroughly analyze them before investing. Experienced investors understand the need to study a number of different financial ratios to trade effectively. A companyâ€™s liquidity ratios are every bit as important as its profitability. Here are some important liquidity ratios that investors should study.
The current ratio is one of the most common measures of liquidity. It is calculated by dividing a companyâ€™s current assets by current liabilities. Higher current ratios indicate higher levels of liquidity, which is generally a good indication of financial health.
A current ratio between 1.5 and 2.0 is usually a good indicator that the company has sufficient liquidity to cover its debts. However, the average varies by industry, so you will want to compare it to the industrial average and other equities that you are considering investing in.
The quick ratio is a similar metric, but is a bit more conservative. The ratio is calculated by dividing the sum of cash, marketable securities and accounts receivable from current liabilities. This ratio factors for the fact that some current assets are more convertible than others. Therefore, it is arguably a more reliable measure of liquidity for many industries.
However, the actual liquidity depends on the types of current assets that the company holds. Some companies tend to have other assets that are easily convertible to cash, so the current ratio may be a perfectly reasonable ratio. The nature of the current assets is actually much more important than the exact ratio used. It is a good idea to research the company in more detail by using an analysis tool such as http://www.trendsinvesting.com/stock-screener.
The cash ratio is the most conservative liquidity ratio. You calculate it by dividing the summation of cash and marketable securities by current assets. It is calculates the companyâ€™s ability to pay off its current debts in the absolute worst case scenario.
Of course, the cash ratio has some issues of its own. The biggest limitation with it is that the value of the marketable securities that the company owns may easily decline in value before they need to be liquidated.
This is particularly concerning when companies own large volumes of a single asset, because they could drive the value down by trying to liquidate it. As a result, they wonâ€™t be able to get the amount of money that they are requesting, which makes the cash ratio somewhat of an illusion. These situations are uncommon, but they do occur sometimes. You will need to find out what the firmâ€™s diversification strategies and overall holdings are before investing in it.