When investigating whether or not an organization is a worth while, or potentially profitable investment, it is crucial to consider the following financial ratios in your research.
Liquidity financial ratios are sometimes referred to as balance sheet ratios since most of the variables are taken from the balance sheet. Liquidity ratios measure the short-term solvency of a company. In other words, they indicate a company’s ability to meet its short-term financial obligations. These financial ratios are generally based upon the relationship between current assets and current liabilities.
The current ratio is one of the most commonly used financial ratios to measure a company’s short-term financial strength. It is arrived at by following the formula shown below:
Current Ratio = Total Current Assets / Total Current Liabilities
Current assets are the assets that are expected to be converted into cash in the next operating cycle. The cash from current assets is used to pay off current liabilities, which are scheduled for payment during the next operating cycle. A company should have enough current assets to meet its current liabilities. The higher a company’s current ratio, the higher their margin of safety is since there is a possibility to lose some current assets, such as inventory write-offs or bad debts. If a company has a low current ratio, or less than 1x it indicates a potential short term liquidity crunch, and a possibility that they will not be able to meet their short term obligations.
While a generally acceptable current ratio is 2x, current assets should be twice the current liabilities, a satisfactory ratio is relative to the nature of the business. Moreover, while judging the current ratio, it is important for an analyst to look at the composition of current assets and liabilities. A company may have a very high current ratio of 3x, but if most of the current assets are locked in the form of inventory, a high current ratio may not indicate a good liquidity position. In this case, it is crucial to know the characteristics of the inventory. If the inventory consists of old product that is not selling well, the company may have to write off the inventory and the current ratio may drop significantly. However, if a large portion of their inventory consists of new products that the company is expecting to sell during the next business cycle, a high current ratio is a sign of healthy short-term liquidity position. Similarly, a high current ratio may also indicate a large amount of idle cash being accumulated and not reinvested into the business.
The quick ratio is also referred to as the ‘Acid-Text ratio’. It is considered to be one of the best financial ratios for judging a company’s ability to pay off its short-term debts and is a more difficult test for a company to pass. As mentioned above, inventories are subject to write-offs in certain cases and are therefore considered to be the least liquid component of current assets. While these financial ratios are similar to the current ratio, it excludes inventories from current assets.
Quick Ratio = (Total Current assets – Inventories) / Total Current Liabilities
By excluding inventories, the quick ratio concentrates on the most liquid assets, including cash, government securities and receivables. A higher quick ratio indicates that even if sales revenue were to disappear, the company would still be in a position to meet its current obligations with readily available assets. A quick ratio of 1x is considered acceptable, unless the majority of the quick assets are in the form of accounts receivable. In this case, the pattern of accounts receivable collection needs to be studied to find if the average collection period lags behind the schedule for paying current liabilities. The quick ratio is one of the utmost important financial ratios used to review an organization’s attractiveness when considering investment.
Interest Coverage Ratio
The interest coverage ratio is also called the ‘times interest earned ratio’ and measures the margin of safety available to a company before paying the interest liabilities on their debts. In other words, it indicates the amount of profit a company makes before paying interest. These financial ratios are used by investors and creditors, to judge a company’s financial risk position. It is calculated as follows:
Interest Coverage ratio = Profit before interest and taxes / interest
Interest is a tax-deductible expense. The ability of a company to pay interest is not affected by tax payments. Hence the numerator used in these financial ratios is profit before interest and taxes. A high interest coverage ratio is an indication that the company can easily meet its interest payments even if its profit before tax suffers a considerable decline. A company having a low coverage ratio is perceived to be financially risky since a minor decline in operating profit can result in an inability to meet their interest payments. It is also used by lenders to measure the debt capacity of a company. We hope this has extended your knowledge regarding financial ratios, if you have any further questions, feel free to write in to us and we will respond as soon as we can.