"L" Ratios Liquidity and Leverage

In the world of finance, the word leverage is used for debt.

Liquidity ratios tell you about a company's ability to meet its financial obligations, including debt, payroll, vendor payments, and so on.

• Current Ratio. This is a prime measure of how solvent a company is. It's so popular with lenders that it's sometimes called the bankers ratio. Generally speaking, the higher the ratio, the better financial condition a company is in. A company that has $3.2 million in current assets and $1.2 million in current liabilities would have a current ratio of 2.7 to 1. That company would be generally healthier than one with a current ratio of 2.2 to 1. To calculate the current ratio, divide total current assets by total current liabilities.

• Quick Ratio. This ratio isn't faster to compute than any other--it simply measures the ratio of a company's assets that can be quickly liquidated and used to pay debts. Thus, it ignores inventory, which can be hard to liquidate (and if you do have to liquidate inventory quickly, you typically get less for it than you would otherwise). This ratio is sometimes called the acid-test ratio because it measures a company's ability to deal instantly with its liabilities. To calculate the quick ratio, divide current assets minus inventory by current liabilities.

Leverage ratios tell you how, and how extensively, a company uses debt. In the world of finance, the word leverage is used for debt.

• Interest coverage. This measures a company's margin of safety: how many times over the company can make its interest payments. To calculate interest coverage, divide income before interest and taxes by interest expense.
• Debt to Equity. This measure provides a description of how well the company is making use of borrowed money to enhance the return on owner's equity. To calculate the debt-to-equity ratio, divide total liabilities by owners' equity.

ACTION POINT: Understand the value of liquidity and leverage for your company's financial health.

Operating Ratios

...these measures provide an assessment of a company's operating efficiency.


By linking various income statement and balance sheet figures, these measures provide an assessment of a company's operating efficiency.

• Asset turnover. This shows how efficiently a company uses its assets. To calculate asset turnover, divide revenue by total assets. The higher the number the better.

• Days receivables. It's best to collect on receivables promptly. This measure tells you in concrete terms how long it actually takes a company to what it's owed. A company that takes forty-five days to collect its receivables will need significantly more working capital than one that takes four days to collect. There are different methods to calculate days receivables. One way is to divide ending accounts receivable by revenue per day.

• Days payables. This measure tells you how many days it takes a company to pay its suppliers. The more days it takes, the longer a company has cash to work with. There are different methods to calculate days payables. One way is to divide ending accounts payable by cost of goods sold per day.
  

• Days inventory. This is a measure of how long it takes a company to sell the average amount of inventory on hand during a given period of time. The longer it takes to sell the inventory, the more the company's cash gets tied up and the greater the likelihood that the inventory will not be sold at full value. To calculate days inventory, divide average inventory by cost of goods sold per day.

ACTION ITEM: Evaluate your operation through the ratios above.

Profitability Ratios

These measurements evaluate a company's level of profitability by expressing sales and profits as a percentage of various other items.


By themselves, financial statements tell you quite a bit: how much profit the company made, where it spent its money, how large its debts are. But how do you interpret all the numbers these statements provide? For example, is the company's profit large or small? Is the level of debt healthy or not?

Ratio analysis provides a means of digging deeper into the information contained in the three financial statements. A financial ratio is two key numbers from a company's financial statements expressed in relation to each other. The ratios that follow are relevant across a wide spectrum of industries but are most meaningful when compared against the same measures for other companies in the same industry.

These measurements evaluate a company's level of profitability by expressing sales and profits as a percentage of various other items.

• Return on assets (ROA). ROA provides a quantitative description how well a company has invested in its assets. To calculate ROA, divide net income by total assets.

• Return on equity (ROE). ROE shows the return on the portion of the company's financing that is provided by owners. To calculate ROE, divide net income by owners' equity.

• Return on sales (ROS). Also known as net profit margin, ROS is a way to measure how sales translate into bottom-line profit. For example, if a company makes a profit of $10 for every $100 in sales, the ROS is 10/100, or 10 percent. To calculate ROS divide net income by the revenue.

• Gross Profit Margin. A ratio that measures the percentage of gross profit relative to revenue, gross margin reflects the profitability of the company's products or services.

• Earnings before interest and taxes. (EBIT) margin. Many analysts use this indicator, also known as operating margin, to see how profitable a company's operating activities are. To calculate EBIT margin, divide operating profit by revenue.

ACTION POINT: Evaluate your operations profitability based on the profitability ratios above.

Using Financial Statements to Measure Financial Health

...they tell three different but related stories about how well your company is doing financially.


The three financial statements offer three different perspectives on your companies financial performance. That is, they tell three different but related stories about how well your company is doing financially.

• The income statement shows the bottom line: it indicates how much profit or loss a company generates over a period of time.
• The balance sheet shows a company's financial position at a specific point in time. That is, it gives a snapshot of the company's financial situation--its assets, liabilities, and equity--on a given day
• The cash flow statement tells where the company's cash comes form and where it goes--in other words, the flow of cash in, through, and out of the company.

Another way to understand the interrelationships is as follows:

• The income statement tells you whether your company is making a profit
• The balance sheet tells you how efficiently the company is utilizing its assets and how well it is managing its liabilities in pursuit of profits.
• The cash flow statement tells you whether the company is turning profits into cash.

ACTION POINT: Understand your companies health through the lens of the three key financial statements.

The Cash Flow Statement

The cash flow statement doesn't measure the same things as the income statement.

A cash flow statement gives you a peek into a company's checking account. Like a bank statement, it tells how much cash was on hand a the beginning of the period, and how much was on hand at the end of the period. I then describes how the company spent its cash.

If you're a manager in a large corporation, changes in the company's cash flow won't typically have an impact on your day-to-day functioning. But you can affect cash flow in your company. And it's a good idea to stay up to date with your company's cash flow projections, because they may come into play when you prepare your budget for the upcoming year. For example, if cash is tight, you will probably be asked to be conservative in your spending. Alternative, if the company is flush with cash, you may have opportunities to make new investments.

If you're a manager in a small company, you're probably keenly aware of the firms cash flow situation and feel its impact almost every day. The cash flow statement is useful because it shows whether your company is turning profits into cash--and that ability is ultimately what will keep your company solvent. You can see in the example below that cash flow of $95,500 was generated.

STATEMENT OF CASH FLOWS, 2004

Net Income $347,000
Depreciation $42,500
Accounts receivable $(43,000)
Inventory $(80,000)
Prepaid expenses $(25,000)
Accounts payable $20,000
Accrued expenses $21,000
Income tax payable $8,000

Cash Flow from Operations $291,000
Property, Plant, Equipment $(7,500)

Cash Flow from Investing Activities $(7,500)

Short-term Debt $(91,000)
Long-term borrowings $90,000
Contributed capital $0
Cash dividends to stockholders $(188,000)

Cash Flow from Financing activities $(188,000)

Increase in cash during year $95,500

The cash flow statement doesn't measure the same things as the income statement. If there is not cash transactions, it cannot be reflected on a cash flow statement. Notice, however, that the cash flow statement starts with net income. Then, through a series of adjustments based on the increases and decreases in asset and liability accounts from the balance sheet, the cash flow statement translates this net income into cash.

In general, a company looks to three sources of cash: ongoing operations, investment activities, and financing activities. It's traditional to start with ongoing operations.

Accounts Receivable - the amount that customers owe for products and services.
Accounts Payable - the amount the company owes its vendors for supplies but not yet paid for.

Investment activities can be:

• Cash the company uses to invest in financial instruments or property, plant and equipment.
• Proceeds from the sale of plant, property and equipment
• Proceeds from converting its investments into cash.

Financing activities include raising money by borrowing in the capital markets and issuing stock. Dividends must be paid out of cash flow; they represent a decrease in cash flow.

ACTION POINT: Understand the activities that affect the companies cash position.