In today’s uncertain market, finding a stock that can weather an economic downturn is every investor’s objective. One place to look to determine if a stock is worth the investment is the company’s balance sheet. A strong balance sheet allows a company to get through periods of economic uncertainty and gives investors confidence in their investment. Key balance sheet metrics give insight into a company’s strengths and reveal if a company has the flexibility to stand the test of a market downturn.
Measuring Liquidity
Liquidity refers to how easily a company can convert assets into cash to pay off outstanding debts. It is essential during periods of economic downturn as companies typically still have debt obligations to meet despite having less revenue. Companies struggling with liquidity will find it difficult to secure credit and cover expenses during short-term periods of unpredictability.
Common metrics used to measure liquidity include the current ratio and the quick ratio.
Current Ratio: (Current Assets / Current Liabilities)
A company’s current ratio reveals a company’s ability to pay off its current liabilities within a year. Typically, a current ratio between 1.5 and 3 is considered acceptable. When a company has a current ratio of less than 1, it cannot meet its current obligations with the current capital on hand.
Quick Ratio: (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
The quick ratio measures how well a company can pay off its current obligations with assets that can be quickly converted into cash. Like the current ratio, a quick ratio greater than 1 is a good indication the company can meet its current obligations. Investors may be skeptical of a company with a quick ratio of less than 1 as it’s a sign the company isn’t taking in enough revenue to cover its short-term liabilities.
Measuring Solvency
Along the same lines as liquidity is solvency, but whereas measuring liquidity assesses a company’s ability to repay debt in the short-term, solvency indicates how well a company can repay its debt on an ongoing basis. Instead of focusing on current assets and liabilities, solvency ratios focus on how quickly a company can repay its long-term debt.
The debt-to-equity ratio and the interest coverage ratio both measure solvency.
Debt-to Equity Ratio: (Total Debt / Total Shareholder Equity)
The debt-to-equity ratio measures how much of a company’s operations are financed with investments from shareholders compared to creditors. A company with a lower debt-to-equity ratio, generally a ratio of 1.5 or less, means that shareholders are financing more of a company’s operations compared to debt. Investors should look closer before investing in a company with a high debt-to-equity ratio, as a ratio of greater than 2 is generally considered risky since the company is operating with more debt. In the event of liquidation, creditors are prioritized, leaving less funds available for shareholders.
Interest Coverage Ratio: (Earnings before interest and taxes / Interest Expense)
Companies typically pay interest on their debt with earnings. The interest coverage ratio assesses if a company has enough earnings to cover its interest payments. When a company cannot make enough money to cover the interest due on its loans, it may be a sign it’s close to bankruptcy. Interest coverage ratios of less than 1.5 should serve as red flags to investors that the company is a risky investment and not generating enough earnings to cover its interest expense.
Measuring Profitability & Efficiency
At the end of the day, profitability in the long-run is key. Companies that can use their assets or equity efficiently to generate earnings will generally find success.
Return on Assets Ratio: (Net Income / Average Total Assets)
The return on assets ratio assesses how well a company uses its assets to generate profit. It can give more insight into a company’s profitability than relying solely on net income. If a company has a higher ROA, it means it efficiently uses the equipment and property it owns to make money. Generally speaking, investors want a company to have a ROA of about 5%, but an acceptable metric varies by industry.
Final Thoughts
A company with a strong balance sheet is a good indicator of a recession-resistant stock, and these metrics can help identify companies worth the investment. As with any investment, remember to do research before moving forward, including comparative analysis of companies of similar sizes and across similar industries.
Sources:
- Current Ratio Explained: a Vital Liquidity Metric
- Quick Ratio Explained: a Key Financial Metric
- Return on Assets (ROA) Explained: Formula, Calculation & Interpretation
- Interest Coverage Ratios: All You Need to Know | Toucan
