In the last post, we discussed profitability ratios. This time we will take a step towards understanding the Liquidity and Leverage ratios. To give you a perspective, liquidity is how quickly can you convert your assets into cash and leverage is what % of the debt you use to drive growth in your company.
Liquidity Ratio
Current Ratio = Current Assets/Current Liability
Use: Address the solvency concern in the short term
How to assess this formula
- Check the trend across a period of at least 5 years versus the competitors
- This can increase and decrease because of "n" number of reasons. Important is that this should be more than 1 and in most industries, it is kept to more than 1. It can be less than 1 as well sometimes because the average inventory cycle can be really short where the current ratio of less than 1 can be quickly addressed. If the ratio is very high then the assets must be taken from current assets to non-current assets to generate higher returns. It is generally agreed that current assets give lower returns than non-current. The assets may not convert to cash, for eg., inventory may not convert to cash due to a sudden change in the market dynamics.
Acid Ratio = (Cash & Equivalent + Marketable Securities + Account Receivable)/Current Liabilities
Use: Just a stricter version of the Current Ratio
Cash Ratio = (Cash & Equivalent + Marketable Securities)/Current Liabilities
Use: How much of the liability can you pay with cash or equivalent
How to assess this formula
- Check the trend across a period of at least 5 years versus the competitors
- The cash Ratio is highly volatile and it changes every day. The higher it is better it is. The issue is that it changes frequently and nobody can assess if the end-of-the-year cash ratio is correct or not.
- The cash ratio can increase due to certain asset liquidation or M&A. A very high ratio is also concerning because that means the management is not putting cash to better use.
Leverage Ratio
Debt Ratio = Liabilities/Assets
Use: Are the assets enough to pay off the liabilities of the company
How to assess this formula
- Check the trend across a period of at least 5 years versus the competitors
- The higher the ratio the worse it is. A higher ratio means that the ability of your assets to pay off the debt is decreasing. The ratio also tells how much of the assets were financed by debt or equity.
- There can be a few caveats that we need to take care of. The assets are calculated at the book value rather than the fair value. So if the ratio is 60%, in actuality it could be 75% which can be a bit concerning.
- The liabilities could be mostly current or non-current. The split is not provided because of which one has to dig deeper to see if it is the actual case.
Debt to Equity Ratio = Liabilities/Equity
Use: Strategy ratio which tells you how much leverage your business is.
How to assess this formula
- Check the trend across a period of at least 5 years versus the competitors
- You cannot say a high leverage ratio is good or a low leverage ratio is better. It needs to be used in conjunction with the Debt ratio. If the debt being used is able to generate a high amount of assets then the management would be fine with the high leverage ratio.
- The use of debt creates a gearing or lever effect which results in generating higher returns versus using equity money if the company does well. On the downside, it also creates huge losses if the company doesn't generate enough revenue.
Interest Coverage Ratio = EBIT/Interest Expense
Use: Ability of the company to pay off the interest amount
How to assess this formula
- Check the trend across a period of at least 5 years versus the competitors
- The ratio tells us the ability of the company to pay the interest expenses.
- It won't tell you if the business can collapse. So it must be used with other leverage ratios in conjunction.
Hope you had a good read. Cheers!
