by elmads

This is the second part of the Liquidity & Debt Metric series. If you have not read the 1^st part yet, I’ve provided the link down below.

“Fundamental Analysis – Liquidity Metrics Part 1”

A company’s survivability is based on how secure their financials are. The one who posses a strong balance sheet can survive any, if not all economic downturns.

Quick Ratio (Liquidity Metric)

This is a metric to see if a company can specifically pay their short-term obligations with their most liquid assets. Assets that can be easily converted within 90 days, assets that retains its value just like cash itself.

Formula:

Quick Ratio = (Cash & Cash Equivalents + Marketable Securities +Accounts Receivables) / Current Liabilities

Probably you’re thinking why do we need to use this metric when we have already the Current ratio? That’s actually a good question. By the way, do you still remember the formula for Current Ratio?

Current Ratio = Current Assets / Current Liabilities

The problem with this formula is within the Current Assets. Although, when we say current assets, it’s the assets that can be converted within a year, but what if the company would suddenly need to pay their financial responsibilities in less than 3 months? Remember, not all current assets can be quickly converted to cash, unfortunately. This is where quick ratio comes into the picture, it focuses on the the assets that can be converted to cash within 90 days. This is what differentiates Current Ratio from the Quick Ratio.

Quick ratio is actually more of a conservative liquidity metric. It is literally when the shit hits the fan and the company QUICKLY needs money to pay their highly important financial responsibilities. This where their highly liquid assets will help them to pay those financial responsibilities, hence the term, QUICK RATIO.

We’ll breakdown each portion of the constituents of the Quick Ratio Formula (Cash & Cash Equivalents + Marketable Securities +Accounts Receivables)

• Cash & Cash Equivalents are automatically cash meaning it is very liquid.                                          –
• Marketable securities are assets like notes and bills, or stocks that can be converted to cash within a day or more.
• Accounts receivable are the invoice that is owed to the company by another company or their customers for the products and services that they have sold via credit. Most businesses opt for a payment window between 10-30 days.

These three are under the “Current Assets”, but unlike their other peers within the same category, the three are mostly near to cash liquid level. Maybe your thinking what are the other peers I am pertaining to? These are the Inventories and prepaid expenses.

Inventories of a company are not highly liquid, because most of them cannot be converted into cash immediately. Its liquidity may vary depending on the business model and the industry. For instance, retailers cannot convert all of their inventories immediately (within the day), not unless they significantly mark down their prices so that they could sell their inventory and convert it to cash. Unfortunately, this could be detrimental for the company, as their revenue & profit would be significantly hit in the process.

Furthermore, prepaid expenses assets are not included, although they’re part of the current assets. This is because they are advance expenses that will be realized, used and be benefited in the future, such as rent or insurance contracts which were paid upfront.

Let’s us go ahead and compute Quick Ratios, shall we? we’ll use Facebook’s, currently known now as META, 2020 financial statement.

META Quick Ratio = ($17,576 + $44,378 + $11,355) / $14,981

  = $73,289 / $14,981

  = 4.89

This means that META can pay, not just fully, but even 4 times the amount of their total current liabilities. It’s like saying that even if their total current liabilities increase 4 times its current amount, META would not still even find it hard to pay those short-term liabilities with their arsenal of high liquid assets. That’s how strong their balance sheet was in 2020.

Total Long-Term Liabilities to 5 Year Average Free Cash Flow (Debt Metric)

Debt is a double edged sword, it can propel companies into achieving faster growth, or be the cause of their demise. A business possessing debt comes with responsibilities, and that is the interest payments they need to pay to their bondholders. To understand what are bonds and its relationship with a company’s debt, see my blog titled “Bonds Asset Class”.

Long-term debts and Long-term liabilities are riskier than the short-term (less than a year) debts and liabilities. This is due to the unpredictable interest rate environment in the future. If rates go up, long-term debts will be substantially impacted as the costs of interest on long term debts will be higher (more expensive). This in turn will have a negative effect in a company’s profits.

Doing the Long-Term Liabilities / Free Cash Flow ratio is a way good way to know if the company’s Free Cash can immediately pay off their Long-term liabilities if needed be. To do that, we should see first the lifeline of the company and that is their income. Take note, value investors don’t just use the net income in the income statement of the business, because net income in accrual accounting takes into account deprecation & amortization which are non-cash charges. We look at the cash flow statement and its cash accounting method, this is where owners/shareholders/investors will see their part ownership of the true and real earnings of the company.

Fundamentalist investors use Free Cash Flow from the cash flow statement. Why? because the cash flow statement tracks the actual and true flow of money in the business. Our focus is the flow of money itself, the story from the start of receiving the revenue cash to where it went. To know more about this, see my blog “The Cash Flow Statement” and “Free Cash Flow”.

In this metric we first need to get the Free Cash Flow amount of a company in a given year. To get this we need to access the cash flow statement of the business, then we go to the “Cash Flow from Operations” section then get the total “Cash Flow From Operations” amount and subtract it from the “Capital Expenditures” (which can be seen in the the “Cash Flow from Investing” section). This will give us the Free Cash Flow of the company in that specified year. (Below is Meta’s 2016-2020 Cash Flow Statement)

But wait, there’s more. A year’s worth of data is not actually that accurate because it can change and fluctuate. Factors like global supply chain and pandemic could substantially cause a sharp decline in a business’ Free Cash Flow, or an extremely good year for the business can skew a higher than expected Free Cash Flow. Being conservative can mitigate those fluctuations and uncertainties, this is why some prefers to get the average 5 years Free Cash Flow of the company, so that we could have a good baseline of how much Free Cash Flow the company has generated for the past 5 years.

Once we’ve obtained the average 5 year Free Cash flow of the company, we then divide it from the company’s current year long-term liabilities. A result of equal or less than 5 is what we want to see. This relays that if the company will continue to produce their average 5 year FCF in the future, then they’ll eventually be able to pay their debts with their FCF within the number of the result, in years. Yet, we also have to be mindful that the company could also expand their long-term liabilities in the future.

Why focus on the Long-term Liabilities, not the Total Liabilities? This is because Short-Term Liabilities or the Current Liabilities are covered already by the Current Ratios and Quick Ratios. Long-term Liabilities are financial responsibilities that could weight down the company over a long period of time. Long-term liabilities are also detrimental for the company’s ability to pay it when the time comes that the national interest rate increases. In short, for a company to pay their long-term liabilities in the succeeding years, they would need their true earnings power (Free Cash Flow) for that.

Let’s again use Meta’s financial statement as an example for the LTL/5yrsFCF.

Formula:

= Long-Term Liabilities (LTL) / 5 yrs Free Cash Flow (FCF) Average

= $16,045 / $17,860.60

= 0.90

This means that Meta can immediately pay all of their Long-term debts if they want to, most especially if their Free Cash Flow increases each year. Meta definitely has a strong balance sheet.

When someone says that a company has a strong balance sheet, that means a company can most likely survive economic problems due to great liquidity levels, good cash balance and manageable debt. It is like an individual’s personal finance core (emergency fund, rainy day fund, debt management, life & medical insurance). Then having a profitable business on top of a strong balance sheet is a business empire that cannot be easily brought onto its knees by its competitors nor any economic crisis.

To Sum It Up

Good to high liquidity and manageable debt are important for a company, because this shows their overall financial health. This signify their financial strength to weather storms and calamities that can be thrown at them.

As an investor, we must not only look on the possible future return on our investments, but we must also mitigate the risk of a permanent capital loss. This is through knowing and understanding the health and safeness of the company we invest in.

Just like what a well known American investor named Peter Lynch has said;

“Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets”.

Peter Lynch

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.