LOS H requires us to:
calculate and interpret liquidity and solvency ratios.
1. Liquidity Ratios
Liquidity ratios are the ratios that depict the ability of a company to meet its short-term obligations. Some of the common measures of liquidity of a company are:
1.1. Current Ratio
The current ratio assesses the adequacy of current assets to pay off the entity’s short-term liabilities. The common norm is 2:1. The current ratio can be calculated by using the formula:
1.2. Quick Ratio
Quick Ratio assesses how adequate are the highly liquid current assets to settle the company’s short-term liabilities. Inventory is deducted as it is difficult to sell it urgently and prepaid expenses are deducted as it is not possible to cash it back once paid. Commonly, 1:1 is the norm. The quick ratio can be calculated using the formula:
1.3. Cash Ratio
This is a more stringent ratio considering only cash in hand, cash at bank, and marketable securities as liquid assets to cover short-term liabilities. A higher ratio is better. It can be calculated as:
2. Solvency Ratio
The solvency ratio depicts the ability of the company to meet long-term obligations. Some of the common solvency ratios are:
2.1. Long-Term Debt to Equity Ratios
This measures the ratio between debt obligations and equity capital. Debt obligations have definite outflow requirements whereas return for equity capital is paid only when the company is capable of giving a return. Due to the above reasons, a lower debt to equity ratio is favored. If it is high, it implies that the company is operating with a high amount of debt obligations for interest payments and repayment. Long term debt to equity ratios can be calculated using the formula:
2.2. Total Debt to Equity Ratio
The total debt to equity ratio can be calculated on a similar line using the formula:
2.3. Debt Ratio
The debt ratio is the ratio of debt to the total asset. We can either find this figure directly in the vertical common-sized balance sheet, or it can be calculated as:
2.4. Financial Leverage
Financial leverage shows the number of assets typically financed through the debt of the company. It shows the degree of leverage of a firm. The formula for calculating the financial leverage ratio is: