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Home | Getting Started | Personal Finance | Q & A | Sample Portfolio | Glossary | About Us |
| Date: Monday 13th 2008f October 2008 10:51:44 AM |
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Evaluating Risk |
| By: Hari Wibowo |
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Last Updated: 11/10/2004 |
| In Investing, we always take risks. It is most important to know what our downside are. How much money can investors lose investing in a particular company? Here are the few risks that investors should know beforehand. |
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The Ultimate Risk |
| What is the greatest risk investors can incur in investing in stocks? Fortunately, we can only lose up to 100% of our investment. Now, losing all your investment is not a good thing. However, there are other investments out there that can cost you more than the amount that you invested in. Here is what I think the characteristics of stocks that gives investor the ultimate risk. |
| Current ratio of close to one and is declining quarter after quarter. |
| Current ratio is the liquidity measure of a company. Ratio of less than one suggests that the company cannot satisfy its short-term obligations. Let's look at Delta Airlines (DAL) as an example. You can look at Delta's balance sheet from here http://finance.yahoo.com/q/bs?s=DAL and calculate its current ratio. |
| Delta Airlines | 30 Jun 04 | 31 Mar 04 | 31 Dec 03 | 30 Sept 03 |
| Current Ratio | 0.63 | 0.69 | 0.75 | 0.75 |
| Things don't look too good at Delta. Current ratio for Delta Airlines not only is less than one but also is getting worse. With the current rate, half of Delta's creditors will not get any payment, unless the company manage to obtain a new loan to pay them up. I must say here that the chance of bankruptcy is really huge. Generally, a 'safe' current ratio is 1.5 and above though this varies with the industry. |
| Operating Income that is less than interest expense. |
| Another signs of companies that may go bankrupt is when it cannot cover its interest expense from its business operations. This occurs when operating income is less than interest expense. In the short term, these companies may survive. They can tap into their cash and current assets to pay for interest expense. But as current ratio declines, watch out. Not only do they have to worry about interest expense, these companies now need to worry about paying their current liabilities as well. |
| I must caution however that a lot of start-up companies will fall into this category. This does not mean that they will go away. Some of them will grow revenue fast enough in the future and therefore, their operating income will exceed interest expense. Furthermore, these companies normally have an abnormally high current ratio (above 3) |
| Generally, I prefer companies that have operating income that is at least twice its interest expense. Some investors might invest in companies that has higher interest expense than its operating income. However, I also expect these companies to increase their operating income in the future. If not, they are as good as being bankrupt. Case in point is Delta Airlines. |
| In the next page, we will analyze Delta Airline a little bit deeper. |
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