Liquidity Ratios

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Liquidity Ratios

A class of financial metrics that is used to determine a company's ability to pay off its short-term debt obligations. Generally, the higher the value of the liquidity ratio(s), the larger the margin of safety that the company possesses to cover short-term debts. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns.

Working Capital Ratio (a.k.a Current Ratio):
This ratio compares the value of what a company owns (Assets) with the value of what it owes (Liabilities). It's generally a good idea to own more than you owe! It is a test to determine if the company has enough Assets over Liabilities to continue their business without needing to borrow. Examples of typical company Assets include: Cash; Investments; Accounts Receivable (money the company is owed but hasn't collected yet); Inventory; Buildings; Equipment. Examples of typical company Liabilities include: Accounts Payable (bills the company hasn't paid yet); Accrued Expenses (e.g., payroll and payroll taxes), Income Taxes owed; Debt. About 2:1 is normal for manufacturers; 1:1 is normal for utilities.

Total Current Assets	= Working Capital Ratio

Total Current Liabilities

Quick Ratio:
Also known as the "acid test," this ratio specifies whether your current assets that could be quickly converted into cash are sufficient to cover current liabilities. A firm that had additional sufficient quick assets available to creditors was believed to be in sound financial condition. About 1:1 is normal; higher is better. Anything better than 1 is considered acceptable. This is a relatively severe test of a company's liquidity and its ability to meet short-term obligations.

Cash + Marketable Securities + Accounts Receivable (net)	= Quick Ratio

Current Liabilities

Long-term Debt:
A small change isn't considered a serious negative. If increasing, why? Is the ROE much higher than the interest rate the company has to pay on borrowed money? If a company can borrow at a rate a few percentage points below the ROE, and debt isn't excessive, debt isn't necessarily bad. Using other people's money to make more money is good management.

LT Debt to Equity Ratio:
Normal Long-term Debt to Equity Ratio is less than 25% debt. Short-term debt is ignored. There is normally enough cash available to pay the short-term debt. Ratios are more meaningful if compared to other companies in the same industry.

Long-term Debt	= Long-term Debt to Equity Ratio

Total Equity

Total Interest Coverage:
How many times does PreTax Profit exceed the interest paid on LT debt? If less than 3, turn the page (find another company). If less than 5 investigate -- Is the ROE greater than the interest rate at which the company can borrow money? If the company's pretax profit only exceeds the payment on interest by only 2-3 times and there is a downturn in the market, the company may collapse. Any number below 5 is worrisome. A number below 3 is very worrisome.