Cash is King
In times of uncertainty like this companies with more than enough cash are seen as safer. This is because even if revenue declines, they will still have enough cash to pay the bills. In addition to cash, liquid assets, which can easily be converted to cash without affecting their market price, can also be a good measure of how safe a company is. The quick ratio is a good measure of this. The quick ratio is defined as (Cash + marketable securities + accounts receivable)/current liabilities. Lets break that down.
Examples of marketable securities are certificates of deposit, common stock, and most often, government bonds. Marketable securities earn some return but remain very easy to convert to cash. Accounts receivables are when a business delivers a product or service but plans to receive payment at a later date, similar to holding IOUs. Current liabilities are essentially debts the company has to pay within a year.
The quick ratio then is measuring how well a company could meet its short term liabilities using its cash, converting marketable securities to cash, and collecting cash from accounts receivables. If a company has a quick ratio of less than 1, that means that without selling assets, it cannot meet its short term liabilities. Which, in times like this is a major problem. Looking for companies that have an investment grade credit rating and a quick ratio above 1.25 would be a place to start looking for safe companies. Companies that go into downturns with excess cash often perform better as they can acquire struggling companies when their valuations are at their lowest, they have easier times getting loans if they need it, and they are far less likely to go bankrupt.
Before buying a stock it could be a good idea to check the company’s quick ratio.
Stay tuned to read about where I will explore a strategy of buying companies with strong quick ratios and shorting those with weak quick ratios in periods of high market volatility.