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Fundamental screening: filter documentation – Part 4

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In Part IV we discuss current and quick ratio, as well as the Asset Turnover Ratio and finally the Net Profit Margin. With regard to the Altman-Z score, there was already a separate article that you can consult through this link.

fundafilters4

Current Ratio

current_ratioThis ratio is used to determine to what extent an enterprise is able to settle its debts in the short term (the so-called liquidity of an enterprise). ‘Short-term’ refers to debts paid during the current financial year. The ratio reflects the ratio between current assets (liquid assets included) + cash assets (all assets of a company which are generally less than 1 year of service to the company) and short-term debt. Current assets include: inventories (both raw materials and finished products), outstanding receivables, securities (shares, etc.). Examples of short-term debt are the supplier credit, debts on current account and tax debt. The higher the outcome, the better the liquidity position of the company. A number lower than 1 indicates that there is more short-term debt than current assets. This means that it will be difficult or even impossible for the company in question to pay short-term debts. The question ‘what is an acceptable current ratio’ is difficult to answer because this figure is very sector-bound. A ratio of 2 is more or less widely accepted as a safe liquidity position.

However, some nuance is in place. A number (much) higher than 2 actually says that the company has too many current assets. Please note that the stock of a company is included as current assets, which could have a significant impact on the calculation of the current ratio. And keep in mind that those goods have not yet been sold. A large stock can be normal for a company, but if this is the result of a (strong) falling demand, there may be a (big) problem… The ‘Current Ratio Growth’ compares the current ratio with the ratio of the previous financial year to get an idea of how the liquidity ratio in a company evolves.

Quick Ratio

quick_ratioThe quick ratio provides an answer to the problem we outlined above with excessive inventory. After all, the formula of this ratio is equal to the current ratio with one major difference. Inventory is not taken into account. Only assets that can be converted quickly into cash are taken into account. What ratio you use will depend mainly on the type of company you are investigating. For a company that supplies its products almost immediately to the customer, the current ratio can be used. In this case, the stock is quickly converted into cash. For companies that have a large stock of raw materials to make and sell their finished products, this is a lot more difficult. That stock can not be converted to cash so quickly, so it’s better to use the quick ratio.

By using these two ratios, you can also determine the extent to which the inventory of an enterprise plays an important role in the company’s current assets. A current ratio> 2 but a quick ratio <1 is a clear indication that the stocks of the company make a significant contribution to the company’s liquidity.

Asset turnover ratio

asset_turnover_ratioThis is the ratio of realized revenue to total assets (expressed in monetary value). To calculate the asset turnover ratio, the revenue is divided by the assets. The higher the value, the more efficient the company uses its assets to generate revenue.

Net Profit Margin

net_profit_marginThis filter tells us something about the relationship between sales and final profits. A company with high turnover figures does not imply that there is a high profit margin. The opposite is true too. Low sales figures can perfectly match with a high profit margin. Companies that provide a service instead of a real product will logically be faced with (much) less operational costs and / or overhead costs. Thus, a larger part of their turnover will translate into their net profit margin. For example, the net profit margin for a supermarket will be a lot smaller (cost staff, stock storage, retail space, …). The smaller profit margin is offset by the fact that sales are much higher.

An example :

Company A has a turnover of $ 1,000,000 in 2016 but, including all costs, the final profit amounts to $ 580,000. The net profit margin is then 58%.

Company B has a turnover of $ 450,000 but significantly less cost, bringing the final profit to $ 350000. The net profit margin is thus 77%.

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