🎙 In part 3 of this series, we’re looking at how to determine whether a company is solvent and liquid — meaning whether it can pay it’s bills and isn’t secretly broke. Knowing the difference will give you peace of mind that your money is invested in a safe company. But how can you determine the financial security of potential investment options? 🤔
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Hey there, friends! And welcome back to Girl on FIRE, the financial independence podcast for independent women.
My name is Priya, I’m a Chartered Accountant, an analyst and the creator of Paper Money Co.
I’m also a fierce financial feminist and the host of this podcast. I believe that a woman who is in control of her money, is in control of her life.
Today, we’re continuing on with part 3 of our 4-part series talking about how to pick individual stocks to invest in.
Last week, we started talking about some of the key ratios you can look at when analysing stocks for individual companies.
And that was all based on a company’s share price, it’s earning and the dividends that it pays out to its’ shareholders.
Today, we’re looking at analysing a company’s financial statements to determine whether they’re able to pay their debts and how smoothly a company is run.
Now, why is this important? It’s important because companies pay dividends from profits, so you want a profitable company to invest your hard earned money in.
Not only that, but a company that’s in good financial health is a more sustainable investment option than a company that’s struggling to get by.
It’s about investing your money in companies that know how to handle your money and use it to grow the business and offer you as an investor a good return.
But before we get started, I want to remind you to head to my website — papermoneyco.com/startinvesting to download your free copy of my Investing Starter guide
It’s totally free, you just need to enter in your email address and I’ll send it straight to your inbox.
It gives you a step by step plan to follow to get your finances ready to start investing, including working with a budget, building an emergency fund and paying off debt.
The sooner you can get your foundation set and get those good money management practices in place, the sooner you can start investing and building your wealth.
If you’re really serious about learning to master your money, then it’s the perfect guide for you, and I’d hate for you to miss out on it.
As always, Girl on FIRE is about learning, so whip out your favourite notebook or journal and get ready to take some notes.
If you’re not into writing things out by hand, you can always find the transcript on my website — papermoneyco.com/gof34.
Okay, let’s dive in!
Why solvency and liquidity matter
The first lot of ratios we’re going to look at today are solvency and liquidity ratios.
Now, what do those words mean?
If a company is solvent it means that they can pay off debts.
And when we talk about companies and debts, we’re not just talking about bank loans. We’re talking about paying invoices from suppliers as well.
So, a company that’s solvent is able to make those payments which means they can continue operating.
Now, here’s an interesting thing that’s good to know. Companies get into a lot of trouble for trading while insolvent.
That means that the company knew they were unable to meet their financial obligations, but they kept doing business.
They’re still selling to customers and making purchases from their suppliers. Suppliers they know they can’t pay.
A company that can’t pay its’ suppliers isn’t going to be paying you a dividend anytime soon. Not only that, but once the news comes out that they’ve been trading while insolvent, the market will freak out and the share price will take a nose dive.
And that means that your capital gains can turn into capital losses overnight.
Now, liquidity is something you’re probably more familiar with. Liquidity means how quickly something can turn into cash.
Think of liquidity like a spectrum. Cash is obviously the most liquid asset of all. It does’t take any time or effort for cash to turn into cash because it’s already cash.
Stocks are fairly liquid because you can sell your holdings for cash within a few days. Real estate is much less liquid. It can take months to sell your house.
And the same principle applies to companies. Liquidity is how quickly they can turn their assets into cash.
So that means both selling the assets they use to operate the business, but also the goods and services they sell to their customers.
For example, let’s say a company owns a building in the best part of town, close to all these amazing cafes, tons of parking, walking distance from public transport.
And that place sells like hotcakes on the market. On the other hand, they also own a warehouse in the bad part of town that’s always getting broken into.
It’s a dilapidated building, it’s got all sorts of structural problems. And it sits on the market for years before anyone shows the slightest bit of interest in it.
So, now you have two assets: hotcakes building and a dilapidated building. Now, which one is more liquid? The hotcakes building is more liquid, right?
Because the building can be sold and cash can be received from that sale a lot faster.
And the same logic applies for the inventory they sell. We’ve all seen this before. There are dresses where your size is completely sold out on the first day.
And then there are dresses that just don’t sell and they get a big red sale sticker slapped on them.
So, solvency and liquidity are both ways of showing how easily or quickly a company can pay off its debts. Do they have enough cash to meet their financial obligations?
Ok, so how can we determine whether a company is solvent and liquid? First of all, in the financial statement, a company actually has to state that they are solvent.
This is one of the responsibilities of the board of directors. They have to sign a declaration saying that these statements were prepared on the basis that the company is still solvent and they have no knowledge otherwise.
And they reasonably expect the company to remain solvent in the near future. But we all know that people lie.
Companies lie about being solvent all the time. And that kind of fraud is hard to pick up because it’s intentionally being hidden.
So, doing your ratios will give you a little extra comfort. Now, of course, companies committing fraud can fudge the numbers as well.
But that’s why this isn’t as easy as just looking at a company’s profit figure to decide whether or not to invest in them.
This is just another piece of the puzzle to help you figure out whether or not this is a good investment for you.
So, let’s look at some solvency ratios you can calculate from financial statements.
Debt to equity ratio
First up we have the debt to equity ratio which shows how much debt a company has compared to its’ equity.
Essentially, how much money the company has borrowed vs how much money is invested in the company.
Having a lot of money invested in a company can be a good sign. It’s a sign that the market is expecting a good return and they believe the company can deliver.
It’s a sign that this company is valuable in the market. Also, debt has different types of rules compared to money invested by shareholders.
When a company has money invested by shareholders, they can choose whether or not to pay a dividend.
And investors can still make money without the dividend when the share price increases. They’ll make a capital gain as the company grows and it’s share price rises.
On the other hand, if a company is funding it’s expansion with debt it means they’ll need to be making interest payments. And those interest payments eat into their profit.
Not only that, but they’ll eventually need to pay back the principal amount that they borrowed. Which could be 10s or 100s of millions of dollars.
And remember what I said in episode 25 about companies paying dividends. They can have the best profit in the world but if a company doesn’t physically have cash in the bank, you won’t be getting a cash dividend.
Debt to asset ratio
And the next solvency ratio I want to talk about is the debt to asset ratio. This shows how much debt a company has relative to its’ assets.
It’s calculated by taking the total liabilities and dividing it by the total assets. Now, why is this important?
It’s important because companies need to keep paying their suppliers and keep paying their debts. And if they have a ton of debt that means less profit to pay to investors.
Think of it like your own finances, right? You have debts like student loans or credit card debt or a mortgage. And you have assets like your savings and your retirement accounts.
How much money you send to your savings is going to be restricted by how much debt you need to pay off.
Because the more debt you have, the higher your payments are. And the higher your debt payments are, the less money you have leftover to grow your wealth.
Not only that but having high debt in comparison to your assets also means you have a negative net worth. Your overall wealth is hindered because you owe someone money.
Well, the same thing happens to companies. They need money to grow the business. They need money to pay dividends to shareholders.
And if they’re spending all their money paying off debt, then that means lower returns for shareholders.
FIRE & investment calculator spreadsheet
Before we move on, I want to ask my Girls on FIRE for a favour. If you’ve listened this far into the episode then you’re probably enjoying it, right?
So, here’s what I’d like you to do next. Pause this episode for a few seconds and head on over to papermoneyco.com/podcastreview.
I want you to leave a rating and review for Girl on FIRE because it helps me provide better content based on what you’re enjoying the most.
It helps other women out in the internet wilderness come and find us as well.
And it’s also a great way to support this show for free, and for that I’d love to send you a little something to say thank you.
So, once you’ve done that, take a screenshot of your submitted review and email it to me at email@example.com.
If you do that, I’ll send you a copy of my FIRE and investment calculator. Which, if I do say so myself, is pretty damn amazing.
It’s how I plan for my early retirement and my wealth. It shows me how my wealth is going to grow, when I can retire and how long my money will last.
And it also has a separate tab that takes Australia’s superannuation into account as well.
And you can use it to analyse companies and different investment options when you’re picking stocks too which just so happens to be what we are talking about in this very same episode.
I’ve never actually seen anything like it before, so it’s pretty special. And I’m currently not offering that spreadsheet anywhere else except for Camp FIRE members.
Not in my shop, not to my email list — it’s a ghost. So, this is kind of a money-can’t-buy type deal.
The only way to get your hot little hands on that spreadsheet is by submitting a rating and a review, taking a screenshot and emailing it to me.
That URL again is papermoneyco.com/podcastreview. I’ve made it nice and easy for you.
So, go hit pause and do that right now. It’s okay, I’ll wait.
Okay, that concludes my little ad-break, so let’s get back to it.
Now, when it comes to liquidity ratios, there’s really only one ratio that I want to draw your attention to today. It’s the cash ratio.
The cash ratio is a measure of how quickly a company can pay its’ debts using cash.
Yes, companies can always sell off assets to pay off debts. But with the cash ratio, we’re only looking at how much cash they have right now, to pay off their debts.
It’s calculated by taking total cash and dividing it by short term liabilities. A higher cash ratio means that a company can pay off all it’s short term debt with cash and still have cash left over.
So, why is the cash ratio important? It’s important because short term liabilities will be due within the next 12 months. And if a company doesn’t have the cash to pay it off then that’s a red flag.
They either need to take out another loan to pay that off. Or they start selling off income producing assets to pay it off. Or they default on their loan and head towards becoming insolvent.
So, those are the ratios I wanted to share with you today. Now, of course, there are many more ratios than what I’ve shared with you in two episodes.
And there’s a lot that goes into analysing and understanding a company’s financial statements.
I mean, people make whole careers out of doing this. And they spend years studying it. I should know, I was one of those people.
So, this series is really just the tip of the iceberg. Just to get those brain juices flowing about the kinds of things you need to be aware of.
At the very least, I wanted to show you that picking stocks properly is not a quick and easy thing. Picking stocks by chance, yes, absolutely it takes 2 seconds and a cat can do it.
But picking stocks based on sound financial analysis and judgement is not so easy. It takes a lot of time and a lot of work. And it carries a lot more risk because it’s very easy to make the wrong choice.
And I’m not telling you that to turn you off investing. I’m telling you that because I don’t want you to make a misguided investment and lose your money.
Next weeks’ episode
And that’s all I have for you Girls on FIRE today!
My challenge for you this week is to pick a listed company, have a look at their financial statements and see what you find.
Before you put your money anywhere, I recommend you get comfortable with looking at these statements and understanding what they mean and what they tell you about a company.
On next weeks’ episode we’re going to wrap up this series by taking a look at some of the non-financial factors to consider when choosing individual stocks to invest in.
It’s going to be a super interesting episode so you’re definitely not going to want to miss it.