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Calculate Financial Strength Ratios

Examine a company’s financial strength to avoid the 98-pound weaklings that can wreck your portfolio performance.

Examining a company’s financial statements isn’t a lot of fun (unless you’re an accountant or attorney general), but there’s plenty of worthwhile information to be derived from a closer look at the balance sheet and income statement. There’s no need for a lot of number crunching, though—a handful of ratios can give you a good snapshot of a company’s fiscal fitness.

Current Ratio

The most common test of a company’s financial strength is its current ratio (also called the working capital ratio). The current ratio, shown in Example 4-22, assesses a company’s ability to pay off debts that are due in the next twelve months from readily available assets, including cash on hand, accounts receivable, and inventory.

Example 4-22. Formula for the current ratio

Current Ratio = Current Assets / Current Liabilities

Current assets and liabilities come from a company’s balance sheet, which is a financial statement required for each quarterly and annual SEC filing. Be sure to use Total Current Assets and Total Current Liabilities, not Total Assets and Total Liabilities, which include illiquid assets, such as plants and equipment, and long-term debt. Figure 4-10 calculates the current ratio using the balance sheet entries for current assets and liabilities.

Figure 4-10. Calculating the Current Ratio and Quick Ratio in a spreadsheet

Current ratios can ...