Tools for Finding Safer Shares (Part 2) – The Quick Ratio

Something happened a short time ago – January 24th, 2011 – that shines a spotlight on the issue of finding safer shares.  Australia’s giant retailer, Woolworths (WOW), lowered its guidance for the first half of 2011.  Today’s earnings release cited the following conditions that led to the revised forecast:

•    Consumer Confidence Levels
•    Inflation
•    Interest Rates
•    Global Economic Conditions

The revision itself is not that drastic – from a previous estimate of NPAT (Net Profit After Taxes) between 8 and 11% growth down to the current estimate of 5 to 6% growth.  Even though the expectation for positive growth remains in place, the market will take notice and retail stocks should take a hit.

However, if you have been thinking of investing in the retailing sector, a potential slowdown in consumer spending is not necessarily a reason to stay out of the sector.  In fact, depending on your investment strategy, it may be a good time to start shopping around for solid retail stocks that may soon be available at relative bargain prices.  So let us continue our discussion of tools you can use to find safer shares.

In the context of Woolworth’s revised forecast, it is even more important to look for stocks that can withstand a decline in expected profitability over the next twelve months.  Stocks with lower debt and higher liquidity can better weather a storm without the need to raise additional cash.

If you are a stgoted follower of advancements in consumer electronics, you know there are always new and exciting technologies in the pipeline.  Assuming you are comfortable with the idea of viewing a possible decrease in short-term consumer spending as a buying opportunity, let us look at shares in some Australian consumer electronics retailers.

First, there is JB HiFi (JBH), a discount retailer of home electronics products.  Next, we will look at Harvey Norman Holdings (HVN), another retailer of home electronics and other products with a slightly different business model (franchise operations).  Both these companies are in the GICS (Global Industrial Classification System) Retailing sector.  We are also going to include Woolworths in our comparison, even though their GICS sector is Consumer Staples Retailing.  As you know, they also sell consumer electronics.

Last week we looked at the current ratio as a way to measure whether a company’s current assets are sufficient to cover current liabilities.  Here is how these three companies stack up.

You recall a current ratio of 1.0 means the company has just enough current assets to cover current liabilities.

From this chart, you can immediately see that Woolworths does not, while HVN’s current ratio is above the 1.5 mark many experts feel is safe.  To sharpen the comparison a bit, you need to know the current ratio for the Retailing sector is 1.51, which makes JB Hi-Fi slightly below the sector average and Harvey Norman slightly above.  The Consumer Staples Sector current ratio is 1.04 and Woolworth is slightly below that.

With Woolworth, we have the opportunity to further fine tune the picture by looking at the current ratio for American competitor Costco, which may be entering the Australian market.  Costco’s current ratio is 1.18.

These comparisons tell us WOW may not be the safest share out there right now.  It is highly unlikely Woolworth is at risk of bankruptcy, but if the downturn in consumer spending is more severe and longer lasting than expected, they conceivably could find themselves in the position of having to raise cash, either through additional borrowing or through issuing more stock.  Neither is good for the share price.

The current ratio provides a less than ideal measure, since it includes inventory as a current asset and in the retail business inventory is sometimes liquidated at steep discounts.  The quick ratio, which you will find pre-calculated on better financial websites, provides a better measure, since it excludes inventory from the calculation.  For your information, here is the formula use to calculate the quick ratio:

Cash and Cash Equivalents + Marketable Securities + Accounts Receivable/Current Liabilities

As you can see, the ratio gets its name from the fact these assets can be quickly converted to cash.  Let us add the quick ratios to our comparison chart for the three consumer electronics retailers we are looking at:

Obviously, Woolworth looks even riskier, but what happened to JBH?  This is a great example of the value of looking at multiple ratios when analyzing potential shares.  The dramatic difference between JBH’s current ratio and its quick ratio can only mean one thing – most of their assets are tied up in inventory.

Could you call this comparison conclusive evidence that HVN is the safest share choice of the three companies?  Not necessarily.  First, let us add the Sector comparisons , which appear in parentheses, to the chart:

HVN still looks good, but now one wonders what is going on with that company’s inventory management.  Although their ratios are below the sector average, both WOW and JBH follow the pattern typical of most retailers – inventory represents a significant portion of their asset base.

Some retail investors search for the elusive perfect ratio – the one that shouts to its beholder “Buy these Shares!”  In truth, ratio analysis is a means of narrowing your focus by eliminating shares that do not meet your investing criteria.  No single ratio tells the whole story.

At this point, the prudent thing to do would be to examine HVN further to see how well it performs in other critical areas.  For that, there is no substitute for a thorough examination of a company’s financial statements, as boring as that might be.  As an example, the quick ratio for HVN might be explained by the way it reports inventory.

Those of you with accounting backgrounds have surely already taken notice of the fact that accounts receivables – which is considered an asset in the quick ratio formula – varies from company to company.  To really assess how quickly a company can convert assets to cash needed for current liabilities; you have to know how they convert their cash.  For that, there is an elegant measure most investment sites ignore – the Cash Conversion Cycle.  We will look into that next week.