In the previous article, I discussed Profitability Ratios and Market Ratios. In this article I will be discussing Liquidity Ratios and Leverage Ratios.
Liquidity ratios: These ratios are used to determine debtors’ ability to pay off current debt obligations without raising external capital. It measures a company’s ability to pay its short-term debt obligations and cash flows.
Common liquidity ratios are:
Current ratio: measures company’s ability to pay off its current liabilities (payable within one year) with its current assets like cash, accounts receivable and inventories. The higher the better.
Current ratio = Current assets/Current liabilities
Quick ratio (acid test): measures a company’s ability to meet its short-term debt obligations with its most liquid assets and thus excludes inventories from its current assets.
Quick ratio = (Current assets – Inventories)/Current liabilities
Note that if the company has prepaid expenses it will be subtracted from the current assets as well.
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Cash ratio: the ratio is a stricter measure compared to current ratio and quick ratio. It measures a company’s ability to pay off short-term liabilities using its cash and cash equivalents.
Cash ratio = Cash and Cash equivalents/Current Liabilities.
Values less than one shows that the company cannot meet its short-term debt obligations and has a risk default.
Leverage ratios: measures the debt level of a company or how much of its capital comes from debt and its ability to pay off its debt when due.
Common leverage ratios are:
Debt Ratio (debt to asset ratio): measures the amount of a firm’s assets that are funded by debt. A value less than one shows that the company has more assets than its liabilities and that a greater part of its assets if funded by equity.
A value of more than one shows that the company has more liabilities than assets. A high ratio indicates that the firm might have a risk of default on its loans.
Debt ratio = Total liabilities / Total assets
Debt to equity ratio: measures the weight of company’s debt in relation to shareholder’s equity. A high value indicates that the company is highly indebted. Increased debt will result in increased interest expense which will in turn affect the firm’s earnings. There is also an increased chance of default and bankruptcy. Generally, debt to equity ratio of more than 2 is deemed risky for investors however, this can vary between industries.
Debt to equity ratio = Total liabilities / Shareholder’s equity
The interest coverage ratio shows how easily a company can pay its interest expenses, the higher the value, the better.
Interest coverage ratio = Operating income / Interest expenses
Gearing ratio measures the extent the capital of a business is financed by loans. The greater the reliance of a business on loan capital, the more ‘highly geared’ it is. The higher the borrowings of the business, the more interest must be paid and this will affect the ability of the company to pay dividends and retain profits.
A high gearing ratio indicates a high leverage and a riskier financing structure compared to a company with low gearing ratio.
Gearing ratio and leverage ratio are sometimes used interchangeably but some analysts use long term debt instead total liabilities in calculating gearing ratio. However, this has its own shortcomings because some companies hold lower debts to avoid interest payment while increasing their accounts payable and short-term borrowings.
In the next article I will be be discussing Efficiency ratios.
Ifunanya Ikueze is an Engineer, Safety Professional, Writer, Investor, Entrepreneur and Educator.