As the economic slow-down continues, it shifts investment emphasis to seeking stocks with fundamental strength. As such, balance-sheet strength and adequate cash flow become imperative in choosing or retaining stocks.

Some ways of measuring balance-sheet strength deserve re-examination, while additional measurements have become useful:

> Working Capital Ratio. Ever since investment analysis took shape, working capital has probably been the first balance-sheet item to be studied. This ratio, a.k.a. the current ratio — current assets divided by current liabilities — is often the first calculation.

But the working capital ratio has not proved to be particularly useful in gauging corporate strength. If there are problems, they are usually first observed elsewhere, most likely in cash-flow analysis.

Companies with steady and predictable cash flows, such as utilities, can get by with more current liabilities than current assets.

> Quick Ratio. You don’t hear much, though, about this ratio, also called the liquidity ratio or acid-test ratio. It does deserve use when times are difficult. It can expose a bad-case risk because it measures cash and cash equivalents plus receivables against total current liabilities.

> Debt/Equity Ratio. Long-term liabilities measured against assets are the primary way to assess a firm’s financial strength. In this method, the debt/equity ratio has been supreme — but it has a defect. In the past, corporate balance sheets were fairly simple, with current liabilities, LT debt and share capital often the only items on the right-hand side.

LT corporate liabilities are more complex now, and it is a rare firm whose balance sheet does not contain several LT liability entries.

So, the debt/equity ratio, comparing LT debt and shareholders’ equity, becomes imperfect. In its place, two other measurements assess balance-sheet strength more accurately.

> Equity/Asset Ratio. First, and perhaps quickest to calculate, is the ratio of shareholders’ equity to total assets. A strong non-financial balance sheet will have an equity/asset ratio as high as 0.4 to 0.5.

An alternative is to compare equity to total liabilities.

The simplicity of these ratios can be undermined, though, by considerations of equity vs tangible equity. Many companies have large balance-sheet entries for goodwill and intangibles (such as patents), and many analysts prefer to measure “tangible book value.”

Such an adjustment will naturally change the parameters of debt/equity, equity/asset and total liabilities/equity comparisons.

> Cash-Flow Ratios offer many ways to measure corporate financial strength. One ratio using operating cash flow is especially important: cash flow as a proportion of LT debt. A variation of this ratio is comparing cash flow to total debt, defined as LT plus short-term debt or as LT debt plus current liabilities.

Operating cash flow to LT debt is the single most significant ratio in the Altman “Z score” formula for assessing the risk of corporate bankruptcy.

You can regard a company whose debt can be covered in three or four years as strong by this measure.

> Cash-Flow Adequacy is another point to check. It is operating cash flow relative to the sum of dividends paid, LT debt repaid and capital spending. A company that regularly generates cash to cover, or almost cover, these three items passes the adequacy test.

> Quality Of Earnings And Financial Efficiency are also factors to investigate. The plain-vanilla analysis for this is depreciation and amortization as a proportion of operating cash flow. The lower the proportion, the higher the quality and the greater the efficiency.

These cash-flow ratios are best compared over several recent years. An adequate but declining ratio may be a better warning than a single year’s set of figures. IE