One Ratio To Test The Default Risk Of A Company

risk cubes diceRising interest rates have been the talk of the town. Many expect interest rates to rise in the coming future. Rising interest rates can have big implications on a company’s debt load, especially for companies that are heavily leveraged.  How do we identify such companies? One way is to analyse the credit risk of a company using the current ratio.

When a company is faced with cash flow issues, it can embark on three possible courses of actions.

1)      Sell assets

2)      Raise debt

3)      Raise equity

Of course, the company may utilise not only one, but two or more of the actions above.  These  actions might not be desirable from a shareholder’s point of view. Therefore, it is important for shareholder to know when a company might be reaching the point of taking any of these actions.

Current Ratio

Current ratio is the financial ratio between a company’s current assets and current liabilities. As the definition of “current” in accounting is that both assets and liabilities have to be realized into liquid instruments (Such as cash) within a year.

The equation for calculating current ratio is

Current Ratio = Current Assets / Current Liabilities

For example, based on its latest quarterly report, Keppel Corp (SGX: BN4) has current assets of S$ 17.6billion and current liabilities of S$8.9billion. That gives Keppel Corp a current ratio of 1.98. A ratio of above 1 will means that the company has no urgent liquidity issue as it has almost twice the amount of liquid assets that can be converted to meet its short term liabilities.

However, if we look at Singtel (SGX: Z74), which has a total current assets of S$ 4.99billion on 31st December 2013 and a current liabilities of S$ 7.26billion. Its current ratio is only at 0.69. Typically, that would mean trouble for most companies as they might not have the liquid asset to fulfill its obligations. Luckily for Singtel, it has a business that is generating stable positive cash flow constantly and this ensures it will not fall into liquidity issue even when it has a current ratio that is below 1.

Foolish Bottom Line

The current ratio can be a quick and dirty method of scanning through the financial strength of a company. It isn’t the only way, nor should it be the only ratio that an investor looks at. It is important to go deeper into understanding the business and not by simply relying on a fixed rule when looking at the ratio.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.