Master Class 12: Understanding Quick Ratio & Interest Coverage Ratio

6 Sep 2020  Read 385 Views

Identification of companies with good investment opportunities is something that every investor should know how to do. Similarly, it is equally important to identify companies that do not have good stocks, companies that might be on the verge of bankruptcy, or companies that are unable to bear their own financial burden. The stocks of such companies are doomed to fail, and thus, investment here can prove to be a very bad decision and can lead to the loss of the investor's valuable money.

Hence, it is important to learn how to identify companies that have poor or bad stocks.

This article will take us through some ratios which enable the identification of financially healthy and weak companies. Financial ratios like interest coverage ratio, quick ratio help an investor identify the potential risks attached to a company. These factors give an idea and suggest if the financial health of the company will be sound in the time to come or would decline. They help in identifying those companies which are on the verge of bankruptcy.

We will understand what a quick ratio is and what is an interest coverage ratio and how these two ratios can help you pick and analyze stocks and save you from bad stocks.

Ownership Pattern/ Shareholding Pattern

Promoter Holding

While checking the current status of a company's stability, one must have a look at its shareholding or ownership pattern and check the promoters' holding. For normal to medium scale companies, a promoter holding of around 40-50% is generally considered to be good. It shows that the company will be stable for a long time to come. In the case of larger companies or banks which are worth thousands of crores of rupees, this is not always possible. In these cases, an increasing promoters' holding over a period of time can be considered healthy. This suggests that the company's promoters have trust in the company and its operations and are thus increasing their share in the business. A falling promoter holding is always a negative sign.

Domestic Institutional Investors & Foreign Institutional Investors

Apart from this, in the case of many large companies like banks, where promoter holdings have to be limited or are not possible due to some other reason, one can have a look at their Domestic Institutional Investors (DII) and Foreign Institutional Investors (FII). These institutions include companies like mutual funds, insurance companies, investment banks, or other funds. One may see if there is enough strong holding by domestic and foreign institutional investors. A major share by DIIs and FIIs is a positive sign for the company. If the ownership of the promoters or institutional investors is growing, it means they have confidence in this company to do well.

It is always better to keep an eye on the holdings of promoters, DIIs, or FIIs as they tend to change. For this, you can join Ticker and enable its watchlist feature. This feature will activate alerts for your desired companies, and you can easily be notified about any updates related to the holdings of the company you want.

If promoter holdings, DIIs, and FIIs show an increase, then it's a good sign, and if they're all decreasing, then the company may not be fit for investing. These three figures indicate whether the company's owners as well the market experts, trust the company's operations or not.

Interest Coverage Ratio

An ideal debt/equity ratio should either be 0 or less than 1. But, this doesn't necessarily mean that it is a good investment option. Sometimes, a low debt/equity ratio means that the company might not even be earning profits or doesn't earn enough profits to pay off its interests.

So, how does one identify if that is the case?

This is where the Interest coverage ratio comes to play. It indicates whether a company is earning enough profits to pay back the interests on the loans it has taken. Interest Coverage Ratio is the ratio of Operating Profit against Interest being paid. It takes into account the operating profits as it shows how much profit a company has earned before paying its loan interest.

Interest Coverage Ratio = Operating Profit / Interest

It shows whether a company has taken loans for its expansion or other purposes, and it is capable to pay it back or not. For example, an interest coverage ratio of 10 means that its operating profit is 10 times the interest it has to pay. This shows that the company is earning enough profits so that it may repay the interest, and the company would not close down. 

The higher the interest coverage ratio, the better it is, as its high value is an indicator of a healthy company. Ideally, a company's interest coverage ratio must be at a minimum of 4-5% for it to be considered healthy and profitable.

Have you read our previous Master ClassPrice to Growth (PEG) Ratio

Quick Ratio

The Interest Coverage ratio finds its way through a company's annual operating profit, which is stated in its annual profit and loss statement. A Profit and Loss statement is released once a year and tells us the annual interests. However, a company may also have some short-term liabilities or some short term loans it has taken during a period, which is after the annual financial statements.

Suppose the company has a lot of profit coming at the end of the year, but it has no money to repay the liabilities maturing just in two months. This kind of situation cannot be judged through the Interest Coverage ratio, but through another solvency ratio called the 'Quick ratio.' It is an important liquidity ratio, and its interpretation is very important to understand.

The quick ratio is the amount of cash, cash equivalents, or liquid funds that the company has against the short-term liabilities it has to pay. It indicates a company's ability to instantly use its near-cash assets(assets that can be converted quickly into cash) to pay down its current liabilities.

The quick ratio of a company should be more than 1 for a surety that the company is financially sound. If the company has no debt in the long term, slight relaxations can be considered, yet not too short of 1.

Conclusion

To check whether a company has bad stocks or not, the assessment of just the Debt/Equity ratio is not enough. If a company has an ideal D/E ratio, i.e., it is 0 or less than 1, an investor should then check the company's interest coverage ratio and quick ratio. These three ratios combined will tell if the company is financially sound or is on the verge of bankruptcy. For a more detailed explanation, you can watch this video tutorial: YouTube.

The Checklist

Based on all the series's blogs so far, the following basic checklist would help an investor identify a bad company and thus avoid a potentially bad investment:

The basic checklist until this point should be as follows:

  1. Profitability: First and foremost, a company should be profitable. Even if profit growth has been declining, it should be profitable.
  2. Quick Ratio: Should at least be 1 or around it, or more.
  3. CFO/PAT ratio: The cash flow ratio from Operating Activities against Profit After Tax or Net Profit should at least be 0.8 or more. This shows that the profits shown by the company are actually the cash payments it has received.
  4. Debt/Equity ratio: The Debt to Equity should be less than 1. The best is if the debt is zero.
  5. Sales Growth: Sales growth is the amount by which the average sales volume of a company has grown, usually from year to year.
  6. ROE & ROCE: The Return on Equity should be at least 15%. You may set the bar to even 18-20% as well. However, an ROE of less than 12% is not ideally justified. Also, see the corresponding ROCE.
  7. Interest Coverage Ratio: Interest Coverage Ratio is the ratio of Operating Profit against Interest being paid.
  8. P/E Ratio: The price to earnings ratio establishes a relationship between the price of a share and the earnings per share, thus helping understand how much price can be paid for the stock.
  9. Enterprise Value: The total amount of equity issued and the debt raised is combinedly known as its enterprise value.

Hence, the evaluation of the above checklist will give a basic idea if a company of a company's financial well-being. It would help identify a bad company and help you avoid any bad investment decisions, thus ensuring good returns.

To understand more checkout the next blog: 3 Ways to pick Undervalued Stocks

To read all Master Class series: Click Here 

About the Author: Anuja Khandelwal | 18 Post(s)

Anuja Khandelwal is a finance content writer at Finology. With a bachelor’s degree in Management and a master’s in mass communication and journalism, Anuja started writing blogs as a hobby, which later turned into passion. Together, with her passion for writing and interest in Finance, she wishes to create unique infotainment through her words.

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