Day traders and quant analysts normally look only at market data for trading signals. However, the recent market turmoil has resulted in a breakdown of some reliable forms of technical analysis as most stocks become correlated in an indiscriminate selloff.

As such, some traders are layering in company fundamentals to give additional information on which stocks can survive (and even thrive) during a sharp economic downturn. 

In this article, I look at three metrics that can be used as a first screen for a company’s ability to withstand a sudden economic shock 

Interest Coverage Ratio (Cash Balance / Interest Payments)

The first and most important metric for determining a company’s ability to withstand a severe revenue disruption is the availability of cash to meet interest payments. Failure to meet interest obligations will mean the bondholders are entitled to recapitalize the company which would make the equity worthless. To calculate this metric, use the cash (‘bank’) balance on the balance sheet divided by the annual interest payments from the Income Statement. Unfortunately, lease payments are not stated on the Income Statement and must be added from reviewing the notes to the accounts (this is an essential step since lease obligations are almost identical to debt). 

Typically a cash balance equivalent to 12-18 months of interest and lease payments is considered healthy.  

One additional factor to consider in considering the cash liquidity of a company is the availability of undrawn funding lines. For this, the statements can be searched for ‘revolving’ or ‘undrawn’ credit facilities which can be used during a liquidity crunch. 

Cash From Operating Activities / Operating Income

This is an extremely useful ratio for many purposes but during a recession, it is useful for highlighting the proportion of a company’s earnings that are cash earnings. The net income figure on the Income Statement is the company’s profit from its ongoing operations (ignoring debt payments and tax), however, this is not a cash profit and some companies experience trading difficulties due to the lag in converting this profit into cash. 

The cash from operating activities (in the Cash Flow Statement) is a measure of the cash profits the company earned during the period. The ratio between the two metrics is the proportion of profits a company is able to collect in cash during the period.  

Typically companies in distress will have very low ‘Cash From Operating Activities / Operating Income’ ratios below 30%. 

Gross Margin

Gross margin is the ratio of gross profit to revenue and is a measure of the amount of revenue which is available to the company to fund its operating expenses. Low gross margin companies often struggle during economic downturns. Gross margins should only be compared with companies in the same industry, so, for example, Southwest Airlines’ gross margin of 27% makes the company more financially viable than Delta at 12% gross margin. 

Gross margin is more useful for determining the viability of companies in capital intensive industries (such as airlines), for industries such as software which have very high margins (usually over 70%), gross margin is not a useful metric for differentiating between companies.