Liquidity – Current ratio; Quick Ratio; Cash Ratios
Liquidity Ratios
A company with adequate liquidity will have enough cash available to pay its ongoing bills in the short run. Here are some of the most popular liquidity ratios:
Current Ratio
Current ratio = Current assets / Current liabilities
The current ratio measures a company’s ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable, and inventories. The higher the ratio, the better the company’s liquidity position.
Quick Ratio
Quick ratio = (Current assets – Inventories) / Current liabilities
OR
Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable) / Current liabilities
The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio.”
Days Sales Outstanding (DSO)
Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x Number of days in sales
Days sales outstanding, or DSO, refers to the average number of days it takes a company to collect payment after it makes a sale. A higher DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually.
Coverage – Interest Coverage Ratio; DSCR ratio; Loan to Value ratio
A coverage ratio, broadly, is a measure of a company’s ability to service its debt and meet its financial obligations.
The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends.
Coverage ratios come in several forms and can be used to help identify companies in a potentially troubled financial situation.
Common coverage ratios include the interest coverage ratio, debt service coverage ratio, and asset coverage ratio.
Interest Coverage Ratio
The interest coverage ratio measures the ability of a company to pay the interest expense on its debt. The ratio, also known as the times interest earned ratio, is defined as:
Interest Coverage Ratio = EBIT / Interest Expense
where:
EBIT = Earnings before interest and taxes
An interest coverage ratio of two or higher is generally considered satisfactory.
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) measures how well a company is able to pay its entire debt service. Debt service includes all principal and interest payments due to be made in the near term. The ratio is defined as:
DSCR = Net Operating Income / Total Debt Service
A ratio of one or above is indicative that a company generates sufficient earnings to completely cover its debt obligations.
Asset Coverage Ratio
The asset coverage ratio is similar in nature to the debt service coverage ratio but looks at balance sheet assets instead of comparing income to debt levels. The ratio is defined as:
Asset Coverage Ratio = Total Assets – Short-term Liabilities / Total Debt
where:
Total Assets = Tangibles, such as land, buildings, machinery, and inventory
As a rule of thumb, utilities should have an asset coverage ratio of at least 1.5, and industrial companies should have an asset coverage ratio of at least 2.
Other Coverage Ratios
Several other coverage ratios are also used by analysts, though they are not as prominent as the above three:
The fixed-charge coverage ratio measures a firm’s ability to cover its fixed charges, such as debt payments, interest expense, and equipment lease expense. It shows how well a company’s earnings can cover its fixed expenses. Banks often look at this ratio when evaluating whether to lend money to a business.
The loan life coverage ratio (LLCR) is a financial ratio used to estimate the solvency of a firm, or the ability of a borrowing company to repay an outstanding loan. The LLCR is calculated by dividing the net present value (NPV) of the money available for debt repayment by the amount of outstanding debt.
The EBITDA-to-interest coverage ratio is a ratio that is used to assess a company’s financial durability by examining whether it is at least profitable enough to pay off its interest expenses.
The preferred dividend coverage ratio is a coverage ratio that measures a company’s ability to pay off its required preferred dividend payments. Preferred dividend payments are the scheduled dividend payments that are required to be paid on the company’s preferred stock shares. Unlike common stock shares, the dividend payments for preferred stock are set in advance and cannot be changed from quarter to quarter. The company is required to pay them.
The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions to ensure their ongoing ability to meet short-term obligations. This ratio is essentially a generic stress test that aims to anticipate market-wide shocks and make sure that financial institutions possess suitable capital preservation, to ride out any short-term liquidity disruptions that may plague the market.
The capital loss coverage ratio is the difference between an asset’s book value and the amount received from a sale relative to the value of the nonperforming assets being liquidated. The capital loss coverage ratio is an expression of how much transaction assistance is provided by a regulatory body in order to have an outside investor take part.
