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Answer:
Dear
Andrew,
The
recent news from Wall Street serves as a reminder
that even big name companies can run into serious
problems. These problems are often triggered by debt
- if a company owes too much money it can fail.
Therefore,
in your quest for safe stocks, you want to find companies
that have three characteristics:
1)
Plenty of cash
2) Little or no debt
3) Profitability
There
are three ratios that identify each of these components.
You can do the math yourself based on the figures
in a firm's annual report or you can turn to the weekly
research publication, Value Line Investment Survey
(www.valueline.com).
Some
of the information outlined below can be found on
the "Profile" market data pages on specific companies
that you search for using the "Research Stocks" functionality
at BUYandHOLD.
The
Quick Ratio
The
best way to find a company with surplus cash is to
use the quick ratio. This ratio compares a company's
liquid current assets (actual cash on hand plus accounts
receivable (money owed to the company by its customers
and clients) with its short-term debt or current liabilities
(rent the company owes, money it owes its suppliers
and the like).
If
a company has a quick ratio of 1 it means its current
liquid assets are equal to its short-term liabilities.
A reasonable ratio, especially in the current economic
environment, would be 2.0 or 2.5. That means current
liquid assets would be at least 200% or 250% of current
liabilities.
Note:
When you study various ratios, you may come upon one
called the current ratio. It is very much like
the quick ratio but it also includes the company's
inventories as part of its current assets. Except
during a very robust economy, it is difficult if not
impossible for most companies to quickly convert inventories
into cash. In that respect, the current ratio (at
this time) is a somewhat less realistic ratio.
The
Debt to Equity Ratio
The
second ratio you want to focus on is the debt-equity
ratio. This compares the company's debt to its shareholders'
equity.
A
zero debt-equity ratio obviously indicates that the
company has no debt and thus it follows that the higher
the ratio, the higher the debt. A high debt to equity
ratio may also indicate a pattern of very aggressive
financing or large losses.
There
are two versions of the debt-equity ratio. One takes
into consideration only long-term debt. The other
includes both short- and long-term debt. You can use
either. However, if you wish to be very cautious,
then go with the figure that includes both.
Why
you may ask? Sometimes a company will take a portion
or all of its long-term debt and convert it into an
ongoing series of short-term loans. Because the debt-equity
ratio includes both, it gives a more inclusive and
realistic picture of the debt level.
To
meet your criteria of finding safe stocks, you should
aim for a company with zero debt.
Return
on Assets (ROA)
The
third ratio measures profitability. You want the company
you select not only to have adequate cash and little
or no debt, but to also be profitable. Profitability
means it will not be forced to eat up its cash reserve
nor take out loans.
The
ROA simply compares net income to total assets. Any
positive number tells you that the company is on record
as having reported earnings. The ROA typically refers
to income for the past 12 months.
In
your quest for safe stocks, you obviously don't want
to invest in a company reporting very little profit.
Therefore, I suggest looking at companies with ROAs
between 5 and 10 or even higher.
STAY
TUNED: Next week we will look at other helpful
ratios.
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