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So when you're looking at like a margin of safety, when you're investing in stocks, particularly like
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a value stock that might be selling at a reduced price because something is going on with the stock,
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you want to make sure that they can pay their bills just like you or me.
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What's important that we're able to pay our bills and we have actually measures that can we can use
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this to evaluate different companies and their ability to pay their current bills.
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Think of it as the what we call the current ratio and quick ratio, and these are emergency safety tools
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we're going to learn about in this lesson.
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And that's the big question can a company cover their short term debts?
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Or we might not commonly known as bills, but in the finance parlance, we consider them short term
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debts.
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Debts are usually less than a year old or are coming due within a year versus a long term debt, something
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that's going to be, you know, do to pay a year or more out.
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So we're looking at short term some of those coming due right away or within a year.
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So what happens if a company can't cover their debts?
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Bills are coming due, they've got to pay them.
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What?
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What are they do?
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What are some things they can do?
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And they're not good things, particularly for our stock price, so they can reduce their expenses.
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There's different ways to do that.
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One is to layoff people that's always ugly and nasty, especially if you're one of the people getting
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laid off so they can reduce their expenses.
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They can also reduce their expenses by spending less on really key in important areas, such as training
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for their team members, marketing, research and development.
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All these things can have longer term consequences as far as having the company be successful going
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forward, but they may need to reduce their expenses in the short term to meet these obligations.
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Another thing they can do is sell off assets, right?
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They can sell off plants or factories or entire divisions.
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They can sell off, you know, they can do all sorts of things to sell off different assets, equipment,
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you know, all sorts of things they can do.
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Again, thinking long term, these might have been assets that could have been used in the future,
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but now we need to sell them to cover our short term obligations, or we could take on more debt.
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See that happen right where where companies need to service their debt or pay their debt.
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And so they take on more debt with a longer term rate as as term being when it comes do.
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So they use the longer term debt to cover the short term debt.
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And we know of a company never really turns it around and never really gets that under control.
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It's almost like a Ponzi scheme where at some point, you know, all this debt is going to come due
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and they're not going will pay it, and that becomes a problem.
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Or they could cut or eliminate their dividend.
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Remember, dividends are payments are getting paid to shareholders, people like you and I who own stock
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as part of our compensation for investing in a company.
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But a company can decide what they want to pay in a dividend.
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They don't have to pay a dividend so they could reduce that payment amount or they could eliminate that
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dividend altogether.
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That way, cash is not going out of the company to pay us.
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They can use that cash in the company to pay their short term debt might be good for the company, but
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not good for us as far as stockholders.
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So when they do these things, what can happen?
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You know what can happen if they can't cover their debt and they do some of these things?
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What are some possible results in significant?
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What can happen is the stock price can go down.
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Sometimes it can go way down when we start doing these things, particularly if they're cutting a dividend,
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you know where they you know where they're taking that money away from shareholders.
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Sometimes you can have a little opposite thing.
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This is the unfortunate thing where you see companies announce layoffs and their stock price goes up
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because they're cutting off their expenses.
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But the shareholders like the idea that they're not getting their dividend cut or they're doing things
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to try to help improve the company.
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From a shareholder owner standpoint, that doesn't help.
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Of course, the poor people have been let laid off, but that's the unfortunate thing where sometimes
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layoffs can be a good thing for a stock price, but usually certainly for the long term.
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The stock price can go down if they have a struggle covering their debts and if they never recover,
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they're never able to cover their debts if they take on more debt to try to cover the short term debt.
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You know, then they can end up things like filing for bankruptcy or maybe selling off even more assets
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or things that really reduced rates because people know that the company is in trouble and can negotiate
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better things.
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So being able to cover your short term debts is real.
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Important is important for us to be able to measure that and the measures that we would use for that
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are called the current and quick ratios.
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And I'm going to show you how they kind of work here, but that's really the current and quick ratios
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measure a company's ability to service or in effect, pay their short term debt.
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So it's looking at short term debts and their ability to pay that they're easy to calculate.
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I'm going to show you that.
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So we understand that the under lying calculations and what the difference is between them, but they're
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easy to look up and haven't calculated for you, and I'll show you that as well where you can look these
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things up for company so you don't have to do the manual calculation so you don't want to.
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And again, the key is they're looking at short term, not long term debt, things like more like debt
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to equity ratio, things of that.
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Consider more long term debt.
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And these ratios, we're looking at short term ability to pay their current debts and be solvent that
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way.
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So let's start with the current ratio.
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Very common thing that's used in investing is the current ratio.
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Sometimes it's known as the.
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Working capital calculations are working, capital ratio is a very simple calculation, you're basically
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taking your current assets divided by your current liabilities, so current assets with big things like
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cash accounts receivable.
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That's money that people over the company, they bought something on credit, for example.
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Now the owes all the company money so that accounts receivable assets are things like inventory that
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you can sell off and other assets are expected to turn into cash in less than one year.
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So that's the key.
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Current assets are things, and current liabilities are all things that are within what's going to happen
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within one year.
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And these are things that you can return the cash and then you can use those cash, use that cash to
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pay your short term debt.
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So if current assets and then you'd rather buy current liabilities, which are things like accounts
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payable, that's debt or bills that we owe.
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For example, they're coming to accounts payable.
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We have a wages, so we are we are employees money and that's coming up as far as liabilities.
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So we have wages, taxes that we got to pay.
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We got to pay taxes and the current portion of long term debt.
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You know, maybe you have something that, you know, long term debt that's like a 10 year note.
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So you've got to pay off in installments every year.
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So current ratio would look at what the current year your one tenth of that basically would be considered
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as a current liability.
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The rest of the debt is further out from year two through 10.
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So what's going to happen one term in the next year in terms of current liabilities and the killers?
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When you calculate this where we look it up, the higher the number, the better.
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If I have more assets, particularly these liquid assets like cash and accountancy or immaterial, that
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that we can use thing to cover our debt up.
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More of those are better than having more debt, so we want a number above 1.0, ideally the show that
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we can least cover our debts one on a one to one ratio.
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But if we're at 2.0 or a higher number, that's even better.
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And it's also best to compare it against the peers, as in other companies in that in that sector of
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space, you know, somebody who in defense contracts may be treated differently than apparel company
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versus a technology company versus, let's say, like a consumer goods company.
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So all these things that you can still compare them against different sectors, but it's a little bit
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fair to compare it with in the sector.
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So that's the current racial and current assets versus current liabilities.
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Now, for some folks, they want to look at what's called a quick ratio, sometimes known as the acid
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test ratio.
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And the idea of the quick ratio is you're looking at more current, you know, even more liquid or more
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current types of things.
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You can see the formula here where you've got the quick ratio and you're looking a cash or cash equivalents
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of things that can be really turned on cash real quickly.
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Marketable securities, that's like stocks and things that they own or bonds or things that they own,
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that they can get money in from these other companies or marketable securities in accounts receivable.
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Again, money that's owed to the company that's coming in divided by that similar or that same current
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liabilities.
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All this is happening within one year again, and the keys to the quick ratio is that the more conservative
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number than the current ratio, so quick ratio will always be less than a a lower number than a current
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ratio.
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You both want them to be above one, ideally, but certainly the higher number, the better.
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But your quick ratio always be less than your current ratio.
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And the reason for that is it's looking at less assets and looking at assets that are more liquid means
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that can be easily turned into cash faster and real easily without having to maybe take some price reductions
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or things on something.
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So that's why something like inventory they exclude typically will exclude inventory because some inventory,
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especially finished goods, can be turned easily into cash, possibly depending how your sales are going,
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and some might be a little bit more stagnant or not.
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Turn over their inventory, turn over as quickly.
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Think about like if you were a rubber manufacturer, right?
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You harvest and you make things out of rubber.
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And one of your big products is rubber tires that you would you sell to automobile manufacturers?
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But let's say the automobile manufacturing industry is hit hard and they're selling cars, so they're
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not going to be buying your tires.
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And so you're not going to be able to generate that.
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Those that rubber into cash or that inventory, especially raw goods like rubber into into cash quickly
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or as quickly as something like a cash or marketable security or accounts receivable.
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So it's a little bit tougher.
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No more conservative.
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No.
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And again, the higher the number, the better and best to compare against your peers when you look
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at both current and quick ratio.
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So how do we look these?
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So knowing how to calculate the underlying basis of them, you know they're easy to look up to.
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There's different tools you can use, but I'm going to show you one here.
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That's a real easy tool to look at and for screening stocks and for finding finding these numbers.
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And this is Finn Wills he may have used to before.
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It's called Finn with it's a Finn WSJ.com.
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If I values XCOM, you can find it and you when you get to their home page, you want to see where that
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first circle is.
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There you click where it's a screener up in the upper left there you'll find all these different screener
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things and then you want to go down to this little bar.
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Bosworth says like overview, valuation of financial ownership at all this little line below you need
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just click the part worth this financial and then it comes up with this what I'll show, then change
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above that and you can kind of then sort it out by different things.
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You want to screen your stocks for it.
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So let's say I'm interested in consumer stocks, you know, and you know, things like food people would
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eat, for example.
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So I could say, and this is where it's highlighted in yellow, there are.
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These are the choices I made.
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I left everything else the same.
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Let's say I'm looking for things on the New York Stock Exchange, just the New York Stock Exchange versus
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the Nasdaq.
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They can leave that for all stocks, but I'm going to say New York Stock Exchange, and I'm looking
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at really large companies.
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So I'm just for curiosity.
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I'm looking at large companies and you can see in terms of bill there where I'm looking at consumer
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defensive stocks.
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Consumer defense, it would be like stocks that are going to sell because no matter what's happening
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in the market, right, so people are going to buy food, people are going to buy household cleaning
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products or things like toothpaste were worth something like a more consumer cyclical stock or discretionary
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stock like, let's say, shoes.
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You don't have to buy shoes or certainly a name brand shoes like a Nike, but you probably do want to
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buy some food, for example.
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So that's just how they organized these different sectors or industries.
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So I selected that.
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And then you'll see in the middle part there, I've got this big red square there where it says, you
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know, Kerr and quick are that's your current ratio and your quick ratio so you can stand the stocks.
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They would list them on the left.
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A whole long list of stocks, and you can kind of look at their current ratios.
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And when you do it, you'll see that I pulled a three of them out here just so we could kind of get
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a feel and look at them.
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And some of the companies are well known.
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So I have a Campbell's soup here, so you might know them for making soup served.
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We're famous for so so during recessions and things, people buy lots of soup and you can see that they
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run a current ratio below 1.0.
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So that's a little could be a little scary, but again, they're a little bit more if they can kind
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of count on that money coming in regularly so they can kind of manage around that.
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So Kurt ratio point eight and a quick ratio a point five getting pretty low there.
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But that's something to consider, like if you're comparing Campbell's soup versus other stocks like,
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let's say, Hershey chocolate, right?
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So Hershey Chocolate makes chocolate bars and good chocolate products has a current ratio of one point
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four.
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So above that 1.0 we're looking for, that's good and a quick ratio.
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The more acid test or the more challenging or more consumer numbers at a one point.
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Also, in terms of their ability to meet their short term obligations, they're really good shape.
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And then another one to compare would be like General Mills.
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They make cereal like Cheerios cereal, for example.
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Believe they still own you'll play yogurt or if they sold it off, I'm not sure, but they but they
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own a lot of different types of food and packaged food type products.
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You can see they're at a current ratio point seventeen point five.
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So if you're looking just at that number, you could say in comparing these three companies, we were
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seeing at least three you might be interested in investing, you'd say, well, at least as far as meeting
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its short term obligations, a margin of safety.
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Hershey chocolate would be the better bet in comparison to the other two companies.
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Again, also time when comparing within its industry, I happen to look up Nike, for example, just
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for fun, and Nike runs a current ratio of two point five.
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Oh, and a quick ratio of one point eight.
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You think about that, they need more of a margin of safety for a consumer discretionary stock.
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So if things go bad in the economy or Nike struggles for something, maybe they had a big shoe recall
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or some scandal, which they've had in the past, of course, too.
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As far as the manufacturer issues the they need to be able to meet their short term debt so they carry
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a little bit more cash and things on hand to meet those obligations and thus their current ratio and
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a quick ratio, or two point five and one point you don't eat all versus these lower numbers for these
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discretionary or, excuse me, these defensive consumer stocks things that people are probably going
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to buy.
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So again, current ratio in quick ratio.
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Great way to get a quick look at a company and its ability to meet its current debt.
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It's a great margin of safety tool because if the stock prices down, but I think a good current ratios
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and quick ratios, you know, that shows that they're able least meet their obligations and then hopefully
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have a rebound.
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But you want to look at a lot of other factors too, of course.
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But this is two ratios that can really help you.
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So is understanding their short term obligations and ability to meet them.
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