Debt Ratio
The debt ratio is the total debt a company holds in comparison to its assets.
A ratio over 1 can be concerning as the company has more debt than assets.
Example 1:
The company has $100 million in assets, thru a combination of real estate, cash, product, etc.
The company has $80 million in debt.
The company has a debt ratio of .8
Example2:
The company has $100 million in assets, thru a combination of real estate, cash, product, etc.
The company has $150 million in debt.
The company has a debt ratio of 1.5
I like to look for companies with a ratio of 1.
Current Ratio
The current ratio measures the company’s ability to pay all the debt it has that expires within one year.
The current ratio includes:
Current Assets: cash, inventory, accounts receivable, and other current assets that can be liquidated if needed within one year.
Current Liabilities: accounts payable, wages, taxes, short-term debt, and the current portion of long-term debt.
Current Ratio = Current Assets/Current Liabilities
Solvency Ratio
The solvency ratio is similar to the Current Ratio but instead measures the company’s ability to meet its short-term and long-term debt obligations.
It can be defined simply as (Post-Tax Net Profit + Depreciation)/(Short + Long Term Liabilities)
This is more comprehensive as it measures the company’s ability to meet its debt long term as well as short term. This can help you determine the company’s risk of going bankrupt or not.
It is very important to understand different industries will have different ratios and you should measure a company vs its peers to determine true health.
Again a ratio under 1 here shows a company can meet its obligations.
Quick Ratio
Quick Ratio =
Method 1
(Current Assets – Inventory – Prepaid Expenses )/ Current Liabilities
Method 2
(Cash + Cash equivalents + Securities + Accounts receivable) / Current Liabilities
Method one measures items that can not be liquidated, while method two focuses on assets that can be turned into cash.
The quick ratio in other words is the dollars per debt it can liquidate.
Example: Company has a quick ratio of 1.2. It can liquidate $1.20 dollars per $1 of debt. In this scenario that would mean they can cover their debt then.
Again it is important to compare vs peers. A higher ratio can mean the company has a health debt ratio, but they may not be using their capital to the best extent possible. Inversely a company with a low quick ratio may be at risk of having to raise capital or do share offerings, possibly even bankruptcy.
Putting it all Together
Whether you are short term, or long term investing debt can have an impact on share price movement.
Companies with bad debt, or debt ratios could be looked at unfavorably and may have to do share offerings that could lead to a dilution in the stock price. This could make it riskier swinging long positions or call positions.
Rapidly growing companies may have a higher debt to equity in order to expand faster, and inversely older companies with established revenue may have a smaller debt to equity as they don’t need to expend much more through debt.
