Financial Ratio Analysis: Liquidity, Debt, and Asset Turnover
Liquidity Ratios
Liquidity ratios measure a company’s ability to meet its short-term obligations.
- Current Ratio: Current Assets / Current Liabilities. An ideal value is between 1.5 and 2. A ratio less than 1.5 may indicate problems with short-term payments and a higher probability of insolvency. A ratio greater than 2 may suggest that the company has idle current assets and low profitability.
- Quick Ratio (Acid-Test Ratio): (Realizable Assets + Available Assets) / Current Liabilities. An ideal value is approximately 1. A ratio less than 1 may indicate insufficient liquid assets to meet payments. A ratio greater than 1 may suggest excess liquid assets and low profitability.
- Cash Ratio: Available Assets / Current Liabilities. An ideal value is approximately 0.3. A lower value may indicate problems meeting payments, while a higher value may suggest low profitability.
- Days of Cash on Hand: Available Assets / (Annual Sales / 365). This indicates the number of days the company can meet payments with its current available cash.
- Days of Cash to Cover Operating Expenses: Available Assets / (Annual Operating Expenses / 365). This indicates the number of days the company can cover operating expenses with its current available cash.
- Fixed Assets to Total Assets Ratio: Fixed Assets / Total Assets. This reports the weight of fixed assets in relation to the total assets.
- Fixed Assets to Short-Term Debt Ratio: Fixed Assets / Current Liabilities. An ideal value is between 0.5 and 1. A negative value may indicate that the company will struggle to meet its current liabilities even if it converts all of its assets into cash.
Debt Ratios
Debt ratios measure a company’s leverage and ability to manage its debt.
- Debt-to-Equity Ratio: Total Debt / (Total Liabilities + Equity). An optimal value is between 0.4 and 0.6. A ratio greater than 0.6 may indicate excessive debt and a loss of financial autonomy (undercapitalization). A ratio less than 0.4 may suggest excess funds.
- Equity Ratio: Equity / Debt. An optimal value is between 0.7 and 1.5.
- Asset Coverage Ratio: Real Assets (excluding capitalized expenses, actions, etc.) / Debt. A ratio greater than 1 is generally considered acceptable. As the ratio approaches 1, the company is approaching bankruptcy. A ratio less than 1 may indicate technical bankruptcy.
- Unencumbered Assets to Total Assets: Unencumbered Property / Total Property. A larger ratio indicates a greater ability to provide collateral for borrowings.
- Quality of Debt Ratio: Current Liabilities / Total Liabilities. A lower value indicates a higher quality of debt in terms of time.
- Debt Service Coverage Ratio: (Net Income + Depreciation) / Loans. A higher value indicates a greater capacity to repay loans.
- Financial Expense to Sales Ratio: Financial Expenses / Sales. A ratio greater than 0.03 may indicate excessive financial costs. A ratio between 0.02 and 0.03 warrants precaution. A ratio less than 0.02 is generally considered acceptable.
- Cost of Debt Ratio: Financial Costs / Total Debt. A lower value indicates less expensive debt and a better financial situation.
- Average Cost of Liabilities: (Expenses + Dividends) / (Total Liabilities + Equity). Ideally, this should be as small as possible.
Asset Turnover Ratios
Asset turnover ratios measure how efficiently a company uses its assets to generate sales.
- Total Asset Turnover: Sales / Total Assets. A higher value indicates higher sales generation from assets.
- Fixed Asset Turnover: Sales / Fixed Assets.
- Average Age of Fixed Assets: Accumulated Depreciation / Annual Depreciation.
- Current Asset Turnover: Sales / Current Assets.
- Working Capital Turnover: Sales / Working Capital.
- Inventory Turnover: Cost of Goods Sold / Inventory. A greater turnover indicates more sales with less investment in inventory.
- Accounts Receivable Turnover: Sales / Accounts Receivable. A larger ratio is desirable, indicating efficient collection of receivables.
Management Ratios of Collection and Payment
These ratios assess the efficiency of a company’s collection and payment processes.
- Days Sales Outstanding (DSO): (Accounts Receivable / Sales) * 365. Sales should include VAT. A lower ratio indicates faster collection from customers.
- Bad Debt Ratio: Unpaid Amount of Time / Date of Receipt of Sales (whose survival in the period). This should be as small as possible.
- Final Insolvency Ratio: Bad Debt (final period) / Sales. This should be as low as possible.
- Days Payable Outstanding (DPO): (Suppliers / Purchases) * 365. A larger ratio indicates a longer time to pay suppliers (which can be positive).