This pandemic took a huge toll among us and globally. The times has been very challenging indeed. Every week we hear news that companies big and small file for bankruptcy and even worse that layoffs are among workforce is getting higher by the day.
On the contrary, it is somehow a good timing to invest in the stock market since it was in its all time low and way much lower than the 2008-2009 global crisis. However, one has to be cautious in placing a position in the stock market. We are unsure how long such good companies can go and how long this pandemic will ensue.
With this, I have learnt from my MBA a few metrics that can help us evaluate companies using a few fundamentals out of the box. Before venturing further, I would advise that this is just a part of a metric and should be used with other indicators found in the financial report.
We will be talking about ratios. My goal is to help you on how these ratios compare and what do they mean. First ratio is the called the solvency ratio. This is defined by the company’s total networth divided by assets.
Lets talk shortly about networth first. You can derive networth by assets minus liability (assets – liability). Hence networth is how much a company or an individual is worth without the liability. Suppose that you have a car that you are paying monthly amortisation with and it costs 10,000 dollars. However you only paid 1000 dollars and you owe the bank 9000 dollars. With that, your assets (the car) is worth 10,000 however, your networth for that car is 1000 dollars while your liability is 9000 dollars.
So going back to solvency ratio. Lets say that a company is worth a million bucks and has a networth of half million bucks. Therefore, using the formula networth/assets is (1,000,000/500,000) is 0.5 or 50%. The solvency ratio for that company is 0.5. The ideal number for this is at least 50% or more.
Next lets go to a ratio called liquidity ratio. You wanted to determine how “liquid” a company is. It is defined by monetary assets divided by monthly expenses. Take note of the word monetary assets and it means that it is a part of the company’s assets that is can be turned into cash easily. This is actually a part of the company’s net worth that can be converted to hard cash. It does not include those inventories that can’t be sold since you can’t turn that into cash as it is unsold in the first place. If we go back to the above case where a company’s asset is 1Million bucks and its monetary assets is 50% of its networth of 500,000 buck. That is 50% of 500,000 buck which is 250,000 bucks. And lets say that the company’s monthly expenditure is hmmm… 25,000 bucks per month.
Using the data above, we can compute for the company’s liquidity ratio by dividing 250,000 bucks with 25,000 bucks/month. The answer now is 10 months.
So what with 10 months? Well, it means that the company has 10 months of cash to survive without income. With the monthly expenses, it should cover for salaries of employees, logistics, electricity, utility, transportation and all sorts of expenses.
This metric is very useful during this pandemic as income in general is much lower than the previous and many companies does not have any income at all!!!. An example is the airline industry. Just imagine that there are no flights in a lockdown situation and prolong it for several months. You might wonder now why many countries are eager to restart their economy.
The ideal number for liquidity ratio is 6 months, however, given the pandemic I prefer to look for companies with more than 12 months of liquidity ratio. This will now depend on the leader and management styles of an institution. If the company is good on managing a business, it is able to cut down effectively all expenses to brings costs down.
In addition, in my opinion, companies with high amount of inventories in their assets are at a high risk of shutting down. This means that assets unsold will depreciate over time decreasing its value. This is further exaggerated by the decreasing value of money over time.
Those companies possessing less inventories are able to cut costs and adapt quite well as compared to inventory intensive ones. Software companies are a good example of such where there are no or minimal inventories. Another one is the service sector.
Another metric is the debt to asset ratio. This is to determine the amount of debt a company has in relation to its assets. If a company has a debt or liability of half million bucks and its total assets is again 1million, then the debt to asset ratio is 0.5 or 50%.
However, in this scenario, we wanted to be as low as possible. We want the company to be debt free or has minimal debt. The ideal number for this is at least LESS than 50%. But dont be fooled, it doesn’t mean that the ratio of less than 50% is good enough, as you have to take note of a part of the assets that are inventories. Inventories unsold, for whatever reason, with a low debt/asset ratio is a warning sign to forgo investing with it for the meantime.
So basically that it, the 3 metrics namely solvency ratio, liquidity ratio and debt/asset ratio, are some useful tools that you can use in helping you evaluate companies. My tip is to put a list of companies and compare each within a similar sector and try to see which tops the list. Again, this is just a part of the metric to evaluate fundamentals, as there are a lot of variables out there that would determine your pick. Among such includes, the business leadership, the reputation of the brand, turnover rate, previous reports just to name a few.