06 How to Assess a Company's Financial Risks? Four indicators to consider

When investing in US-listed companies, stock investors will consider not only their performance and profitability but also their financial risks.

A strong financial position is crucial for a company's long-term success.

On the flip side, most investors will avoid companies that are financially risky or even on the brink of bankruptcy.

So how to assess a company’s financial risks?

Its financial stability and creditworthiness can be key perspectives.

Financial stability can be evaluated by the debt-to-assets ratio, a key leverage indicator.

We can calculate it by dividing a company’s total debt by total assets.

Generally, a company raises money from both shareholders and creditors to start and expand its business.

If a company’s debt-to-assets ratio is 0.4, it means creditors are entitled to 40% of the company’s assets and shareholders to the remaining 60%.

Capital raised from creditors is considered leverage. Therefore, the higher the debt-to-asset ratio, the higher the leverage.

What is a healthy ratio, then? There is no absolute answer. Generally, a company with a debt-to-asset ratio between 0.3 and 0.6 is considered financially stable.

But sometimes we’d better understand this leverage ratio in the context because it can vary greatly from industry to industry.

For example, banks typically have a higher debt-to-assets ratio because money borrowed from depositors makes up a large proportion of their assets.

However, a high debt-to-assets ratio does not necessarily mean all banks are risky.

Take Bank of America as an example.

As of the end of 2022, the bank has a staggering 0.91 debt-to-assets ratio, with $3.05 billion in total assets and $2.78 billion in total liabilities.

Apart from financial stability, a company’s creditworthiness is also critical to evaluating its financial health.

Three indicators can measure a company’s ability to pay off its liabilities.

First, the current ratio.

It refers to the ratio of current assets to current liabilities, measuring a company’s ability to pay its short-term obligations.

Generally, a less-than-1 current ratio might indicate liquidity problems, while a higher current ratio may suggest better creditworthiness.

However, a high current ratio does not guarantee creditworthiness. That’s probably because the company faces difficulty in liquidating its excessive inventories, or because it is unable to convert its accounts receivable to cash quickly.

On the other hand, a less-than-1 current ratio does not necessarily mean the company is not creditworthy.

For example, as of the end of the fiscal year 2022, Apple’s current ratio was lower than 1, according to financial data on moomoo.

That’s mainly because the company shelled out cash for dividend payments and share buybacks.

To assess a company’s current ratio, we should compare it to the industry average and its historical ratios.

If its current ratio is far lower than the industry average, it may indicate the company has issues paying off its short-term obligations.

Also, if the company’s current ratio declines year over year, it may suggest higher financial risks.

The second indicator to measure creditworthiness is the quick ratio.

Similar to the current ratio, the quick ratio is calculated by subtracting inventories and prepaid expenses from current assets and dividing the result by current liabilities.

The quick ratio is considered a more conservative metric to evaluate a company’s liquidity because its inventory may be difficult to convert quickly to cash and its prepaid expenses may not be refundable.

Generally, a more-than-1 quick ratio indicates the company’s most liquid assets can cover its short-term debt.

Similarly, evaluating a company’s quick ratio involves comparing it with the industry average and its historical levels.

If the company’s quick ratio is far lower than the industry average, or it declines year over year, we should be mindful of the company’s financial risks.

The third indicator is the cash ratio, considered the most conservative metric of creditworthiness.

It is calculated by dividing a company’s cash and cash equivalents by its current liabilities.

The ratio measures the company’s ability to meet its short-term obligations using its available cash and cash equivalents.

Generally, if a company’s cash ratio is lower than 0.5, it may face some financial risks.

A high cash ratio typically suggests the company has sufficient cash on hand.

But it can also mean that the company may not use its cash effectively, as it is not making dividend payments or expanding its business.

Again, let’s take a look at Apple’s financials on moomoo.

At the end of the fiscal year 2019, Apple’s cash reserve topped 100 billion.

Its cash ratio approached 1, which some analysts criticized.

The tech giant then took steps to address this issue through share buybacks and dividend payouts, lowering the cash ratio to 0.31 at the end of the fiscal year 2022.

To wrap up, when investing in US stocks, we must be aware of the underlying companies’ financial risks.

We may use their debt-to-assets ratio, current ratio, quick ratio, and cash ratio to assess their financial stability and creditworthiness to help avoid investment pitfalls.