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Avoid Distressed Stocks With This Easy Formula

Last week we highlighted the current ratio as the single most important statistic in evaluating a company's financial health.

Today I want to take it a step farther and look at how the quick ratio can tell you even more about a stock's near-term financial health.

Quick ratio is useful for any stock investor, and is a good way to further screen Magic FormulaŽ stocks to weed out distressed companies.

What is the Quick Ratio?

The quick ratio is simply a modification of the current ratio.

The textbook definition subtracts out the inventories asset line item from current assets before comparing against current liabilities:

Quick Ratio = (Current Assets - Inventories) / Current Liabilities

This gives you a ratio very similar to the current ratio. The usage is the same: add "years" to the ratio number to see how long a company could survive without generating positive cash flow. The rule of thumb is that anything over 1.0 is OK, and the higher the number, the better.

Why Quick Ratio instead of Current Ratio?

What both ratios are really measuring is a company's liquidity.

Liquidity, simply stated, is how fast can a company turn its assets into cash to pay off liabilities. In your own life, this is easy to illustrate. If you need a large sum of cash NOW, you can get it almost instantly by selling some stocks, but it would take you a month (or likely much more) to get cash from selling your home. Stocks are liquid assets, real estate illiquid.

Now, say an apparel retailer needed cash quickly to pay off term debt coming due. Most of its current assets can be turned to cash at full value relatively quickly. Cash is already cash, and accounts receivable are usually collectible at full price.

The one item that may not be is inventory. The retailer cannot quickly sell off its inventory of out-of-fashion items at full price. It would likely have to sell them at a deep discount to move them at all, which reduces their value on the balance sheet.

Quick ratio simply assumes the company could not immediately liquidate ANY of its inventory! Pretty drastic, but a conservative test of financial health, particularly for makers and sellers of "hard goods" that lose their value sitting on a shelf.

Putting It All Together: Adjusted Quick Ratio

Looking at a current ratio vs. quick ratio for a retailer like Express (EXPR) tells two completely different stories:

Current Ratio = (593 / 351) = 1.69
Quick Ratio = ( (593 - 343) / 351) = 0.71

Using a quick ratio, Express looks like a financial risk, with a figure well under 1.0!

But let's do some adjusting to get the "real" story. Let's start by adding in free cash flow to both ratios, as we did in the other article:

Current Ratio = ( (593 + 165) / 351) = 2.16
Quick Ratio = ( ((593 + 165) - 343) / 351) = 1.18

That looks better! Express generates a good bit of cash flow and is not really a financial risk.

Finally, I really believe the theory behind the quick ratio is a bit too dramatic. In reality, a firm could most likely liquidate most of its inventory at an appropriate discount. In this example, I've assumed a 60% discount on listed inventory value:

Final Adjusted Quick Ratio = ( ((593 + 165) - (343 * .40)) / 351) = 1.77

Conclusion

Quick ratio is an extension of the current ratio, meant to discount a firm's ability to quickly liquidate inventory at full price. It is particularly useful for firms that deal mainly in "hard goods" inventory, such as retailers and manufacturers.

While useful, the textbook definition is too conservative and can be improved by including free cash flow and discounting inventory at a percentage, instead of excluding it entirely.

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