Losing it all.
There is no greater fear in investing than losing most of, if not all, of a stock investment.
In reality, losing it all is a very rare occurrence. But it can happen, even for Magic Formula® investors. Over the past 6 years, a number of MF stocks have essentially gone to zero, including Idearc and Jackson-Hewitt.
In this article, I want to highlight one very simple financial health statistic that can help investors quickly and easily avoid firms that may be facing impending financial distress: the current ratio.The Current Ratio
I consider the current ratio the single most important statistic in evaluating a company's financial health. So what is it?
Let's think about something everyone is familiar with: their own personal finances. Every month, you have cash coming in, usually in the form of a paycheck. Also, you have cash going out, such as mortgage payments, auto payments, insurance, taxes, electric and gas bills, phone bills, and so on.
Now, let's say disaster strikes and you lose your job. All of a sudden, you would have to rely on your other assets - cash in savings, equity in your home, items you can sell, etc. - in order to pay those bills.
How long could you survive?
In essence, this is the question that the current ratio answers for a company.
Statistically, it is calculated like this:
Current Ratio = (Current Assets / Current Liabilities)
The ratio gives us a quick answer as to how long the company could survive should it not be able to generate free cash flow. Take the current ratio and add the word "years" onto the end of it. Two examples:
Boyd Gaming (NYSE:BYD): (325 / 473) = 0.69
What do these tell us? Simple. Nvidia could survive OVER 4 YEARS without generating cash flow, while Boyd Gaming would barely survive 8 months! Pretty obvious which one is a safer pick.Adding Free Cash Flow into Current Ratio
Current ratio is a good shorthand for financial health, but to really get a good feel for near-term financial health, it is imperative to add free cash flow generation to it.
Remember our personal finance example? 95% of us have jobs or some form of steady income. We are not relying on our other assets to pay our bills (liabilities).
Companies are the same way. Most generate sales revenues which are used to pay off those current liabilities, which consist of employee salaries, suppliers, benefits, debt payments, and so forth.
Their free cash flow tells us how much cash is left over after covering liabilities, and paying for maintenance or replacement of assets.
In your household, if you make more than you need to spend every month, that leftover cash is your free cash flow. The concept is the same for a business.
Therefore, if a company has POSITIVE free cash flow, the current ratio should *increase* as time goes on. If it has NEGATIVE free cash flow, the current ratio will *decrease*!
Let's account for free cash flow for the prior example. To do this, I will simply add (or subtract if negative) annual free cash flow from the "Current Assets" figure. I usually take a 3 year average to smooth out any peaks or valleys - cash flow can be a bumpy line item.
Nvidia: ( (4,050 + 641) / 986) = 4.76
Boyd Gaming: ( (325 + 97) / 473) = 0.89
Since both companies have positive free cash flow, their current ratios improve. Still, Boyd is under 1 year of safety, so I would be very reluctant to consider an investment in it.
Here's a second example that illustrates the value of adding free cash flow a little more clearly:
Weight Watchers (WTW) Current Ratio: (304 / 384) = 0.79
With Free Cash Flow: ( (304 + 322) / 384) = 1.63
Weight Watchers goes from being a financial health concern at a 0.79 current ratio to being relatively safe at 1.63 because the company generates a pile of free cash flow year after year.Summing It Up
Current ratio is a nice, simple way to quickly gauge a company's near-term bankruptcy risk. The basic ratio is valuable as a short-hand check of financial health, but adding in free cash flow gives you a more accurate view of how well the company can cover its near-term liabilities.
Like this article? Get our stock reviews and other great content FREE to your inbox. Sign up for the MagicDiligence Newsletter! For a limited time, you'll also get the FREE report, 5 Quick and Easy Tips for Dramatically Improving Your Magic Formula Stock Picks. Get it here!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.