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Debt to equity and current ratio and it’s the significance| How to check the stability of a Manufacturing Company

Note: The fundamental analysis I am about to share (Debt to equity and current ratio) only work in the case of the manufacturing industry and service industry (Hotels, Hydropower, trading companies). Soon I will be writing about how to check the stability of the banking, finance, and insurance sector in Nepal. This is because most of the companies listed in Nepse belong to these particular sectors and they require a separate set of analysis in order to identify their intrinsic value.

As the lockdown continues, the stock market remains closed, and there is no certainty as to when it will open back up again. I personally don’t know what to make of it, but I do know that an impending crash is waiting for us on the other side. There is no proper infrastructure to support an online trading mechanism that would allow everyone to participate, which is the primary reason why the market has been closed in the first place.

Of course, you could try and set up an inclusive online system at this moment, but I not sure if that should be the core priority or if it is feasible at all in the first place. Only a few individuals currently have access to the online systems, and I leave the decision up to you to decide how fair that would be to allow only a handful of individuals to move the market.

I do, however, think that closing down the stock market right now is like trying to use a brick wall to stop a train that is going at 1000 miles per hour. You can be rest assured that after the market opens, there will be a lot of volatility and uncertainty. This is because there has been a massive reduction in government income, remittance flow, foreign currency incomes. This bad situation is further exacerbated by an economic slowdown, distorted economic activities, mass unemployment, reduced FDI, and other dismal economic and financial indicators that indicate that a financial crash and a recession is inevitable.

However, I do believe you can utilize this time to educate yourself about the intricacies of the stock market and to be ready when it finally opens back up. I do want you to always remember this one thing; that the most substantial amount of gains in the stock market are made during a crash. The reason for this is simply because you get to buy stocks at a low price and wait out the storm until prices move back up again.

However, you have to understand that this storm is not passing away anytime soon and will probably last for the next 2-4 years. So don’t invest a lot of money very quickly just because the market is cheap. I would instead suggest an incremental amount of small investments every month. What constitutes small investment is entirely subjective and will depend on your economic status.

As you can see that the unemployment rate is increasing every day, and many companies are having a hard time staying afloat. Many non-essentials companies are simply closing down, unable to sustain themselves or their employees. I can only say that this situation will worsen with the continuation of the lockdown if critical measures are not taken by the government to bail out these companies tittering at the edge of extinction.

But here is a silver lining(if there is one), companies which survive through crises like these are comparably better investments. But how can you tell which companies will provide greater benefits in the future, especially during this time when everything looks bleak?

you can do this by checking how competent its leaders are and how they handle their debt. But since you may not be able to directly verify the competency of the leaders of a company you are interested in, all you can do is to go through their financial statements. This article will help you assess the possibility of a company to survive a pandemic like this and which companies will be better for you to invest in the future if you decide to do so. There are two key indicators you can use to check the stability of the company:

Debt/Equity ratio

The debt to equity ratio tells you how well a company handles its debt. You have to understand that a large amount of debt is not a big problem if that company can efficiently use the debt to increase its income (and its equity). Hence, a company with a large amount of debt and a high Debt to equity ratio is a massive red flag.

You can check the debt to equity ratio of a company by going on to the balance sheet and adding up all the debt related numbers in the liabilities section. Then all you have to do is to divide the total debt by the total equity to get the ratio.

But what is a good debt/equity ratio, right? Well, you should look for companies with a debt to equity ratio that is less than 0.5. Debt to equity ratio of 0.5 means that for every 1 Rs in equity, the company owes 0.5 paisa as debt. Companies with low debt to equity ratios are more likely to come out of this pandemic unharmed and do better in the future.

If you are a very conservative investor, you can divide the total liabilities by the total equity. What this will do is allow you to find the safest companies out there in the market. The caveat, of course, of using this method, is that you may not be able to find many companies to invest because the ratio will be just too high.

Hence any ratio is subjective at the outset and is dependent upon the amount of risk you want to take while investing in a company. Also, I would advise you to look at the previous quarterly reports of the companies you are interested in. This is because companies at this moment are forced to take on more debt to sustain themselves. Hence, you must compare the current debt performance with its past performance to get a clear understanding of how the company is handling its debt. This can be done by plotting out how the debt to equity ratio of the company has changed over the last few quarters and years.

Current ratio

The current ratio of a company tells you how well the company will handle its debt in the next 12 months. This particular ratio is the comparison between the companies’ total current assets and current liabilities(Note: not the total assets & liabilities). The current assets of a company tell you how much income it can generate in the next 12 months, and the current liabilities tell you the amount of money it has to pay out in the next 12 months. An excellent current ratio would be a value that is higher than 1.5. A current ratio of 1.5 means that for every 1.5 Rs it brings into the company, it has to pay out 1 Rs in return. This implies that over a long period incomes will rise higher compared to debt.

A current ratio of less than 1, tells you that the company will be adding nothing to the equity in the next 12 months. And if you are familiar with my last article on EPS and Equity, you know that low equity equates to a low margin of safety and decreases the EPS which in turn decreases the dividend payout. All this means is that the company’s debt in the future will rise faster than it’s income.

Summary

Please be sure that these are not a sure-fire way to tell how a company will do it the future and whether or not you should invest in that company. But making bets based on financial numbers is indeed a lot less risker than doing it without them.

Hence I advise you to look for companies with a low Debt/equity ratio and a high current ratio while also using metrics of comparisons we have talked about in the past. 

Note: Due to a lack of digital data of companies, it will be hard for you to figure out these ratios quickly and you may even have to dive deep into the financial reports of many companies to do so. All you have to do is to understand the basic premise of these ratios, and you will be fine.

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This Post Has 3 Comments

  1. Savishra Kandel

    Really well written! Keep them coming!

  2. Savishra Kandel

    While clicking other links at the end, it says page not available. Will you please check that. And thanks a lot for these articles!

    1. RT

      Thanks bro! Fixed it 🙂

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