What You Should Know about Liquidity Ratios and Penny Stocks - dummies

What You Should Know about Liquidity Ratios and Penny Stocks

By Peter Leeds

Liquidity ratios help you determine whether a penny stock company can pay its short-term debts and obligations. With many lower-priced shares, you will find that many companies can’t! With penny stocks, this category of ratios is the first thing you should check. The good news for you is that liquidity ratios are straightforward calculations.

You can find plenty of penny stocks in great liquidity situations, though, and liquidity ratios help you identify them.

When a company has a strong position from the perspectives of the following liquidity ratios, you know that it is generating money from its operations or has significant assets to keep operating and advancing its business.

Current ratio

To calculate the current ratio, you divide the current assets by the current liabilities. The result gives you a pretty good indication of a company’s ability to pay its short-term obligations, which are due within the next 12 months. Here’s the equation:


Current ratios are a quick way to eliminate from consideration companies that are already in financial trouble or operationally underwater.

When calculating the current ratio, look for a value of one or higher. A current ratio of 0.5 means that the company only has half of the current assets it needs to cover its current liabilities. If that value is 7, then you know that the company’s current liabilities are covered seven times over, which demonstrates that the company is in very strong financial shape from this perspective.

Quick ratio

A quick ratio is a more focused look at a company’s ability to pay its short-term debt. Unlike the current ratio, which considers all of a company’s assets, the quick ratio focuses only on those assets — such as cash, short-term investments, and accounts receivable — that the company can quickly and easily use. Here’s how it’s calculated:


Quick ratios are useful because, although a company may have a strong overall short-term asset position, not all those assets are truly liquid. In addition, the assets may decrease in value if the company is forced to sell them.

With start-up companies or newer penny stocks that are potentially in their growth phase, the quick ratio is important to assess their ability to pay what they owe in the short term. Look for a value of at least 1 from the quick ratio, but higher values are better.

Cash ratio

The cash ratio takes accounts receivable out of the equation when considering a company’s assets. This removes the uncertainty and reliance on getting paid by customers. You are then left with a much more certain and telling number.

You generate a cash ratio by comparing cash and marketable securities to short-term liabilities. Examples of marketable securities include stocks, bonds, and guaranteed investment certificates that are due to mature within the next 12 months. The calculation for the cash ratio is shown in the following equation:


A cash ratio helps you determine whether the company has enough money in the bank and enough easily liquidated investments to cover what they need to have to pay their debts due in the next 12 months.

Look for a cash ratio of at least 1, but much like the other liquidity ratios, the higher the number the better. If you see a cash ratio of 0.5 for example, that means that for every dollar the companies owe in the next year, it only has 50¢.

With penny stocks, the cash ratio is important from the perspective of making sure that the company will stay in business and advance its operations. The cash ratio doesn’t necessarily need to be very strong, however, such as a value of 2 or higher, but look for a value of at least 1. Larger cash ratios are better but not necessarily to be expected in speculative penny stocks.

Operating cash flow

Operating cash flow is a great ratio to watch when dealing with penny stock analysis. The operating cash flow looks only at cash coming in from operations, and divides it by current liabilities. The resulting number illustrates how many times over the cash flow will cover what the company owes in the short term. Here’s the equation:


Unlike the current, quick, and cash ratios, where you should look for a value of at least 1, the operating cash flow could be acceptable at slightly lower amounts. Because other short-term assets could come into play to cover the company’s debts, it could potentially do fine even if its operating cash flow doesn’t do more than cover the current liabilities.

Although a value of less than 1 isn’t a sign for concern, the lower the operating cash flow falls, the more likely it could be a problem. Healthier companies have healthier cash flow and debt coverage, so higher numbers in this ratio are always preferable.

Strong operating cash flow is important with penny stocks because it demonstrates

  • Income: Revenues must be coming in to have a strong operating cash flow ratio. To be able to cover short-term liabilities with operating cash alone, independent of other asset classes, is wonderful for any level of company.

  • Fiscal security: When a penny stock is able to maintain its own operations, it generally won’t need to raise more money. This sort of situation is a good sign for shareholders because it means that the company may be in a position to finance any new undertakings with its own money instead of taking on debt or issuing more shares.

  • Opportunity: When cash flow meets or exceeds obligations, the company is in a position to take advantage of beneficial events as they arise, whether that means hiring workers, paying down long-term debt, buying back shares, or other actions.

  • Demand: A company with strong cash flow is enjoying sales of its products or services, which means that it has achieved a certain level of demand and acceptance among its market.