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Company Valuation Methods - Debt Evaluating

One of the factors you should consider when evaluating a stock is interest rates. This is especially important if the company from which you possess stocks has a debt which it should cover. If the interest rates rise, the company may fall in a very risky environment.

When you want to determine whether a company is in a heavy debt you can undertake several actions. All of the measurements include the reference to the balance sheet of the company. However, if you don't have the time or knowledge to make the calculations on your own, you can refer to one of the many online sources that provide such information.

Before you can make reliable measurements you should first become familiar with the following terms:

  • Current Assets

    Current assets are securities that can be quickly and easily transformed into cash within 12 months. An example of a marketable asset is cash. Assets that take longer than 12 months to be converted into cash are not current assets. For instance, real estate and land cannot be considered current assets since you may need more time to sell them.

  • Current Liabilities

    Under the current liabilities category fall bills that are payable within the next 12 months. The operating expenses of a company fall in this category. Payments on mortgages that should be made within the current year fall in this category. However, other long-term debt is excluded.

In order to make reliable evaluations of a company's debt, you can use the following ratios:

  1. Quick Ratio

    The quick ratio provides you with information on the ability of the company to cover its obligations that are due in the next 12 months.

    Quick Ratio = (Marketable Securities + Accounts Receivable) / Current Liabilities

    You should exclude from the Current Assets the following:

    • Accounts receivable
    • Inventory

    What you actually try to determine is whether the company will be able to cover its current obligations if it has no income from now on and if it sells all of its convertible income.

    If the value of the quick ratio is 1.00, then the company has enough assets to cover its obligations. If the result is greater than 1.00, then the company's current assets are greater than the company's current obligations.

    The important thing to remember is that comparisons between companies from the same industries or sectors should be made. Avoid comparing the ratios of companies that are not from the same industry since their ratios will be completely different.

  2. Current Ratio

    The current ratio differs from the quick ratio since in addition to what the latter includes it also adds Current Liabilities and Current Assets. As a result you get a broader comparison.

    The current ratio provides a measurement of the ability of the company to cover its short-term obligations.

    The current ratio includes the conversion of all assets the company has available. That is why it is generally preferred over the quick ratio.

    A value of 1.00 or greater means that the company will be able to meet its current obligations. Additionally, you should not forget to compare companies from the same industries or sectors.

Finally, if you don't have the time or information to make the estimations on your own you can always refer to the available online sources. No matter which method for retrieving the ratios you select, you should remember that low results mean that you should very carefully consider the viability of the investment.

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