The quick ratio is the ratio of the quick assets to current liabilities. Quick assets are those assets that can be most readily converted to cash. In most situations, the least liquid of the current assets is inventory; hence, inventory is typically excluded when calculating the quick ratio:
The greater the current ratio and the quick ratio, the higher the company's liquidity and the greater the firm's ability to pay its current liabilities when due. By comparing these ratios using a time-series approach, the entrepreneur can see if the firm has improved its liquidity from one period to the next; increasing ratios demonstrate a positive trend, and lowering ratios indicate declining liquidity. A cross-sectional view of the numbers can indicate if the company is more or less liquid than its peers or how the company ranks against the peer group average.
Leverage
A company's leverage ratio measures how much debt the firm has on its balance sheet. Leverage ratios represent another measure of financial health. Generally, the more debt a company has, the riskier its stock is. This escalating risk comes from two primary impacts that accompany higher debt: (1) the firm's breakeven point goes up because of the higher fixed costs associated with the debt, and (2) the volatility of return on equity becomes less predictable and more volatile when debt increases.
The debt to equity ratio measures how much of the company is financed by its debt holders compared with the equity contribution of its owners (shareholders). A company with a lot of debt will have a high debt to equity ratio, while one with little debt will have a low debt to equity ratio. Assuming everything else is identical, companies with lower debt to equity ratios are less risky than those with higher such ratios. The debt to equity ratio is calculated as follows:
Also known as the debt ratio, the debt to total assets ratio can be interpreted as the portion of a company's assets that is financed by debt. The higher this ratio, the more leveraged the company and the greater its financial risk. (We discuss financial risk in greater detail in Chapter 11.) Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries like technology. A debt ratio of greater than 1 indicates that a company has more debt than assets. The debt to total assets ratio is
The interest coverage ratio (also known as the times interest earned ratio) compares the firm's operating earnings to its interest expense; the more the firm can produce in operating profit to cover its interest expense, the lower the risk of defaulting on its debt. It is calculated as follows:
A stricter version of the interest coverage ratio is the fixed charges coverage ratio, which is calculated as
The fixed charges coverage ratio relates the interest and fixed charge payment that the firm is required to pay to the funds that the firm has available to pay them with. Fixed charges are expenses that are incurred and must be paid regardless of sales, profits, or production.
Management Efficiency
Regardless of what kind of industry a company is in, it must invest in assets to perform its operations. Management efficiency ratios measure how effectively the company uses these assets, as well as how well it manages its liabilities.
The accounts receivable turnover ratio measures how effective the company's credit policies are. It is calculated as
This ratio essentially measures how many times a company “turns over” its accounts receivable during the course of the year. If accounts receivable turnover is too low, it indicates the company is being too generous granting credit or is having difficulty collecting from its customers. All else equal, higher receivables turnover is better. A similar measure of efficiency is the days sales outstanding (DSO) ratio, calculated as
This ratio measures the number of days’ worth of sales that are tied up in accounts receivable. You can think of it as the average lag between the date of sale and the date the payment is received on the average account receivable. Entrepreneurs want to keep this number low, as having money tied up in accounts receivable affects the firm's working capital.
Working capital is also affected by the amount of inventory that a firm holds on its balance sheet. A measure of how well managers manage the firm's inventory is the inventory turnover ratio, calculated as
Notice that the numerator has cost of goods sold and not sales. This is because inventory is valued at cost, and therefore the cost of goods sold measure gives a better representation of the inventory's value. Like the accounts receivable turnover ratio, the more times a firm can “turn over” its inventory, the more efficiently it handles its assets. The days of inventory ratio is
It measures the number of days that a firm sits on its inventory before it is sold. The firm would want to hold onto its inventory the least amount of days possible to avoid inventory obsolescence and to increase working capital.
On the liabilities side, the accounts payable turnover ratio measures how a company manages paying its own bills. High accounts payable turnover is a signal that a firm isn't receiving very favorable payment terms from its own suppliers or isn't paying its accounts payable in a timely manner. All else being equal, average to slightly lower payable turnover is better. It is calculated as
While the above ratios focus on current assets and liabilities, a firm must also understand how efficiently management uses the long-term assets they have been entrusted with. The total asset turnover ratio is a catch-all efficiency ratio that highlights how effective management is at using both short-term and long-term assets and measures a company's ability to generate sales given its investment in total assets. It is calculated as
Generally speaking, the higher the ratio, the better it is since it indicates the company is generating more revenues per dollar of assets.
One can also analyze the efficiency of the firm's organizational structure (a topic not reported on the balance sheet). The sales to employee ratio describes how well employees are generating sales for the firm. This measurement can be interpreted as being derivative of the firm's organizational success. The calculation is straightforward:
The ratio can be especially insightful for firms in the “people business,” such as retailers, consultants, and software companies.
It