Assessing a company’s financial stability

The best stock trading opportunities are with financially stable companies, those with little short-term or long-term debt on their books and therefore able to ignore credit market conditions. The opposite, of course, is also true:

The best short selling opportunities are with financially unstable companies, those carrying so much debt they have difficulty meeting interest payments, much less reducing the loan’s principal. These are the companies set for a financial flameout and share price collapse, should business stall.

Financial stability is therefore an important consideration when seeking long or short stock trading opportunities. There are three major ratios for assessing a company’s financial stability: the current ratio, the ratio of debt to shareholders’ equity, and the interest coverage ratio.

The current ratio illustrates how well a company can meet its short-term liabilities with its short-term assets. This demonstrates the company’s chances of survival over the next twelve months, in all but the worst case scenarios.

When seeking stocks to take long in the market, traders should hone in on companies with current ratios of 1.5 or above. Although the absolute soundest companies have current ratios of 5 to 6, with some soaring as high as 40 or more, anything above 1.5 is considered perfectly acceptable by even the most conservative of traders. For short selling, look for current ratios below that level.

The ratio of debt to shareholders’ equity, or debt to equity for short, measures the company’s leverage. A company utilising low leverage hasn’t financed its operations with high levels of debt. Some traders prefer higher debt to equity ratios, considering it a sign of efficiency with accompanying high profit potential for the company. However, with capital and financial markets currently so jittery, companies with lower leverage tend to be the most stable.

For long purchase opportunities, traders should look for a debt to equity ratio of no more than 30%. When short selling, look for companies with a ratio above 50%.

Finally, the interest coverage ratio compares the company’s earnings before interest and taxes (EBIT) to its interest expenses, to ascertain how easily it can maintain the terms of its outstanding debt. Financially sound companies have an interest coverage ratio of 5 or more, short selling opportunities are 2 or below.

Debt to equity leverage and the interest cover ratio both vary by industry, and traders restricting their long trades to the safest ratios % may find some industry sectors outside of their target range. Whether to honour that range when an industry is soaring remains the personal judgment of each trader.