When looking at a company’s financial details while considering investment, a significant item to review is various types of liquidity ratio. This represents a company’s capability in satisfying short-term debt obligations.
We will take a look at some of the key points of an organization’s liquidity ratio, starting with the debt service coverage ratio, or DSCR. The interest coverage ratio measures the ability of a company to pay the interest on their outstanding debts. However, there are other commitments besides interest payments that a company is liable to pay. These include the principal of the debt, lease rentals and principle amount of other interest-free loans. Moreover, since debts are paid out of cash flows, creditors are interested in the amount of cash flow the company earns annually instead of operating profits. The debt service coverage ratio, or the DSCR is a liquidity ratio that measures the ability of a company to pay the interest and principle of all long-term debt. It is calculated as:
Debt Service Coverage Ratio = (PBT+ Depreciation+ Other non-cash charges+ Interest on term loan+ Lease Rental) / (Interest on Term loan + Lease Rental + Repayment of Term Loan)
Financial institutions calculate the average debt service coverage ratio for the period during which the term loans are repayable. Generally, 1.5 to 2 is considered to be satisfactory. A DSCR liqui dity ratio of less than one indicates negative cash flows. In other words, it indicates that the company is not capable of servicing the current debt. Companies in this situation may not be able to raise further capital to fund expansion plans.
Another item to consider when reviewing liquidity ratio, is that every business needs money to finance its daily operations like production and purchasing raw materials. A company may be earning high profits but if it is not able to generate surplus cash, it may face a liquidity crunch situation. There have been many companies in the past that have gone bankrupt despite earning high profits.
In an operating cycle, raw materials are purchased on credit basis, represented as accounts payable in the liabilities section of the balance sheet. Goods are produced and carried as inventory on the balance sheet. Inventory is then sold on a credit basis that is carried on the balance sheet as accounts receivables. Once accounts receivables are collected, the receipts are used to pay-off the accounts payables. This entire operating cycle is also called the working capital cycle. An operating cycle of purchasing raw materials, selling inventory, collecting receivables and paying current liabilities should generate surplus cash, crucial to the liquidity ratio from a company.
Net Working Capital
The net working capital portion of liquidity ratio is more a measure of cash flow than a ratio. It represents the amount of net cash flow generated during an operating cycle. The result of this calculation must be a positive number. It is calculated as:
Net Working Capital = Total Current Assets – Total Current Liabilities
Bankers look at net working capital over time to determine a company’s ability to weather any financial crises. Loans are often tied to minimum working capital requirements. A positive working capital ensures that a company will able to continue its operations and satisfy both maturing short-term debt and upcoming operational expenses. These are the key aspects that make up liquidity ratio, an important part of reviewing a company while considering investment.