Finding great companies for investment is not easy, so how can we find stocks which can give us good return without losing our capital.
Financial Statement analysis can help a lot to understand the strengths and weaknesses of a company. One of the important aspects of financial statement analysis is finding out the liquidity position of the firm. We can use financial ratios called liquidity ratios to analyse cash position of companies and its ability to meet short term money requirements .
A sound company where we should invest needs to have good short term liquidity . Liquidity refers to the ability of a company to meet to pay its short term debts. When the company has liquid assets, it can be accessed and used easily. The most liquid asset is cash.
Liquidity ratio is even more important in sectors that are related to manufacturing and sale of goods, like Cement , Textile , Autos etc .
Here are some liquidity ratios one can look into while doing analysis of a stock.
Current Ratio: This ratio is calculated as the ratio of current assets to current liabilities. The higher the current ratio, the better is the financial position of the company. Higher current ratio means company is well poised to take care of short term liabilities and will not face issues of cash crunch.
Current Ratio = Current Assets / Current Liabilities
Current Assets include cash, current investments, inventories, trade receivables etc. Current Assets can be liquidated easily to get immediate funds when needed and provide financial backbone of operations of company. Current Liabilities include loans (secured or unsecured) which are due to be given in next one year.
Quick Ratio: As mentioned above, current asset includes lots of components other than cash. Cash is always the most liquid asset. So a company with a high proportion of cash as current asset is always better than current asset as inventories .
Quick Ratio = (Current asset – Inventories)/ Current Liabilities.
If two companies have similar current assets, then the company with better quick ratio is preferable. Also we must note that many companies will have good current ratio but low Quick ratio. This simply means that company is piling on inventory and may not be able to sell easily.
Working Capital: Working capital is calculated as the difference between the company’s current asset and current liability.
Working capital = Current assets – Current liability
It means the asset left with the company after paying off its short term liabilities, which it can use for its day to day operation. A positive working capital is a very good sign as it can use it for its growth without taking debts from outside.Usually companies with good operating cash flow have good working capital