The COVID-19 outbreak has negatively affected most companies, with many having to tighten their operating cash flows and such. This could cause an issue when the company has some short-term liabilities that they need to pay for.
During this COVID-19 outbreak, we should focus on investing in companies with strong cash flow and healthy balance sheets, which can help them tide through this tough time.
For this article, we will take a look at 3 key ratios to look out for when investing in stocks during the COVID-19 outbreak.
# 1 Current and Quick Ratio
Both these ratios are important in determining if the company has enough liquidity to pay off its short-term liabilities.
To calculate Current Ratio :
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year.
To calculate Quick Ratio :
The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.
The difference between the current and quick ratio is that the quick ratio is more conservative. The quick ratio only includes the most liquid assets and excludes assets that are harder to sell off such as inventory. When looking at the current and quick ratio of a company, we want the ratio to both be above 1. This will indicate that the company has enough liquidity to pay off all its short-term liabilities.
It is worth noting that for some industries such as airlines, they do not usually have high liquidity ratios, so you will need to take note of that when investing in such industries.
# 2 Free Cash Flow
The Free Cash Flow of a company acts as a key indicator to the business’s health and its overall profitability. It is how much money your business has left after deducting its Capital Expenditure.
Formula to calculate Free Cash Flow:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
An increasing or at least positive free cash flow shows that the business is healthy, able to generate more profits year on year and don’t need to dip into their reserves when paying for expenses.
There is no fixed answer on what is a good FCF number. Generally, a good indicator would be if the company is generating an increasing amount of FCF year on year.
# 3 Net Cash Position
To check if a company is in net cash position, use the company’s total cash and cash equivalents minus total liabilities. If the resulting number is positive, it means that the company has enough cash and cash equivalents to pay off all its liabilities. This is usually a very strong indicator that the company’s financial health is stable.
Do note that for some industries, it is uncommon for companies to have a net cash position. An example would be REITs and real estate stocks since they are leveraged.
Final Tips
These key factors might not be fully applicable for certain industries. For example, companies with a lot of inventory on hand might have a low quick ratio. Generally, a good rule of thumb is to have the current ratio to be at least above 1. The quick ratio is a more conservative approach to determining a company’s liquidity and may not show the full picture at times.
Read Also: 10 Strong Reasons Why You Should Not Be Using Leverage When Investing
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