The Importance of Liquidity Ratios

Liquidity ratios are probably the most commonly used of all the business ratios. Creditors may often
be particularly interested in these because they show the ability of a business to quickly generate the
cash needed to pay outstanding debt. This information should also be highly interesting since the
inability to meet short-term debts would be a problem that deserves your immediate attention.

Liquidity ratios are sometimes called working capital ratios because that, in essence, is what they
measure. The liquidity ratios are: the current ratio and the quick ratio. Often liquidity ratios are
commonly examined by banks when they are evaluating a loan application. Once you get the loan,
your lender may also require that you continue to maintain a certain minimum ratio, as part of the
loan agreement.

Liquidity refers to how easy it is to convert assets to cash. For any business or
individual investor to survive, liquidity is important as cash or money is the
backbone/foundation of any company. If a company cannot collect actual cash from
its customers on a regular and timely basis, the company will soon become bankrupt
and be unable to fulfil its obligations. Having an understanding of a companys
liquidity position will help the business avoid getting into trouble in the future.
The objective of credit analysis is to look at both the borrower and the lending facility being
proposed and to assign a risk rating. The risk rating is derived by estimating the probability
of default by the borrower at a given confidence level over the life of the facility, and by
estimating the amount of loss that the lender would suffer in the event of default
Credit analysis involves a wide variety of financial analysis techniques, including ratio and
trend analysis as well as the creation of projections and a detailed analysis of cash flows.
Credit analysis also includes an examination of collateral and other sources of repayment as
well as credit history and management ability. Analysts attempt to predict the probability that
a borrower will default on its debts, and also the severity of losses in the event of default.
Credit spreadsthe difference in interest rates between theoretically "risk-free" investments
such as U.S. treasuries or LIBOR and investments that carry some risk of defaultreflect
credit analysis by financial market participants.[1]

Price Ratios
Price ratios are used to get an idea of whether a stock's price is reasonable or not. They are
easy to use and generally pretty intuitive, but do not forget this major caveat: Price ratios are
"relative" metrics, meaning they are useful only when comparing one company's ratio to another
company's ratio, a company's ratio to itself over time, or a company's ratio to a benchmark.
1) Price-to-Earnings Ratio (P/E)
What you need:

Income Statement, Most Recent Stock Price

The formula:

P/E Ratio = Price per Share / Earnings Per Share

What it means: Think of the price-to-earnings ratio as the price you'll pay for $1 of earnings. A
very, very general rule of thumb is that shares trading at a "low" P/E are a value, though the
definition of "low" varies from industry to industry.
[InvestingAnswers Feature: The P/E Ratio -- A True Measure of Profits?]
2) PEG Ratio
What you need:

Income Statement, Most Recent Stock Price

The formula:

PEG Ratio = (P/E Ratio) / Projected Annual Growth in Earnings per Share

What it means:
The PEG ratio uses the basic format of the P/E ratio for a numerator and then
divides by the potential growth for EPS, which you'll have to estimate. The two ratios may seem
to be very similar but the PEG ratio is able to take into account future earnings growth. A very
generally rule of thumb is that any PEG ratio below 1.0 is considered to be a good value.
3) Price-to-Sales Ratio
What you need:

Income Statement, Most Recent Stock Price

The formula:

Price-to-Sales Ratio = Price per Share / Annual Sales Per Share

What it means:
Much like P/E or P/B, think of P/S as the price you'll pay for $1 of sales. If you
are comparing two different firms and you see that one firm's P/S ratio is 2x and the other is 4x, it
makes sense to figure out why investors are willing to pay more for the company with a P/S of
4x. The P/S ratio is a great tool because sales figures are considered to be relatively reliable
while other income statement items, like earnings, can be easily manipulated by using
different accounting rules.
4) Price-to-Book Ratio (P/B)
What you need:

Balance Sheet, Most Recent Stock Price

The formula:

P/B Ratio = Price per Share / Book Value per Share

What it means:
Book value (BV) is already listed on the balance sheet, it's just under a
different name: shareholder equity. Equity is the portion of the company that owners (i.e.
shareholders) own free and clear. Dividing book value by the number of shares outstanding gives
you book value per share.
Like P/E, the P/B ratio is essentially the number of dollars you'll have to pay for $1 of equity. And
like P/E, there are different criteria for what makes a P/B ratio "high" or "low."
[InvestingAnswers Feature: Don't Be Misled By the P/E Ratio]
5) Dividend Yield
What you need:

Income Statement, Most Recent Stock Price

The formula:

Dividend Yield = Dividend per Share / Price per Share

What it means:
Dividends are the main way companies return money to their shareholders. If
a firm pays a dividend, it will be listed on the balance sheet, right above the bottom line. Dividend
yield is used to compare different dividend-paying stocks. Some people prefer to invest in
companies with a steady dividend, even if the dividend yield is low, while others prefer to invest
in stocks with a high dividend yield.
[InvestingAnswers Feature: Decoding the Dividend Yield Formula]
6) Dividend Payout Ratio
What you need:

Income Statement

The formula:

Dividend Payout Ratio = Dividend / Net Income

What it means:
The percentage of profits distributed as a dividend is called the dividend
payout ratio. Some companies maintain a steady payout ratio, while other try to maintain a
steady number of dollars paid out each year (which means the payout ratio will fluctuate). Each
company sets its own dividend policy according to what it thinks is in the best interest of its
shareholders. Income investors should keep an especially close eye on changes in dividend
policy.
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Profitability Ratios
Profitability ratios tell you how good a company is at converting business operations into profits.
Profit is a key driver of stock price, and it is undoubtedly one of the most closely followed metrics
in business, finance and investing.
7) Return on Assets (ROA)
What you need:

Income Statement, Balance Sheet

The formula:

Return on Assets = Net Income / Average Total Assets

What it means:
A company buys assets (factories, equipment, etc.) in order to conduct its
business.ROA tells you how good the company is at using its assets to make money. For
example, if Company A reported $10,000 of net income and owns $100,000 in assets, its ROA is
10%. For ever $1 of assets it owns, it can generate $0.10 in profits each year. With ROA, higher
is better.
8) Return on Equity (ROE)
What you need: Income Statement, Balance Sheet
The formula: Return on Equity = Net Income / Average Stockholder Equity
What it means: Equity is another word for ownership. ROE tells you how good a company is at
rewarding its shareholders for their investment. For example, if Company B reported $10,000 of

net income and its shareholders have $200,000 in equity, its ROE is 5%. For every $1 of equity
shareholders own, the company generates $0.05 in profits each year. As with ROA, higher is
better.
9) Profit Margin
What you need: Income Statement
The formula: Profit Margin = Net Income / Sales
What it means: Profit margin calculates how much of a company's total sales flow through to the
bottom line. As you can probably tell, higher profits are better for shareholders, as is a high
(and/or increasing) profit margin.
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Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term obligations. Liquidity
is important to a company because when times are tough, a company without enough liquidity to
pay its short-term debts could be forced to make unfavorable decisions in order to raise money
(sell assets at a low price, borrow at high interest rates, sell part of the company to a vulture
investor, etc.).
10) Current Ratio
What you need: Balance Sheet
The formula: Current Ratio = Current Assets / Current Liabilities
What it means: The current ratio measures a company's ability to pay its short-term liabilities with
its short-term assets. If the ratio is over 1.0, the firm has more short-term assets than short-term
debts. But if the current ratio is less than 1.0, the opposite is true and the company could be
vulnerable to unexpected bumps in the economy or business climate.
11) Quick Ratio
What you need: Balance Sheet
The formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities
What it means: The quick ratio (also known as the acid-test ratio) is similar to the quick ratio in
that it's a measure of how well a company can meet its short-term financial liabilities. However, it
takes the concept one step further. The quick ratio backs out inventory because it assumes that
selling inventory would take several weeks or months. The quick ratio only takes into account
those assets that could be used to pay short-term debts today.
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Debt Ratios

These ratios concentrate on the long-term health of a business, particularly the effect of
the capital and finance structure on the business:
12) Debt to Equity Ratio
What you need: Balance Sheet
The formula: Debt-to-Equity Ratio = Total Liabilities / Total Shareholder Equity
What it means: Total liabilities and total shareholder equity are both found on the balance sheet.
Thedebt-to-equity ratio measures the relationship between the amount of capital that has been
borrowed (i.e. debt) and the amount of capital contributed by shareholders (i.e. equity). Generally
speaking, as a firm's debt-to-equity ratio increases, it becomes more risky because if it becomes
unable to meet its debt obligations, it will be forced into bankruptcy.
13) Interest Coverage Ratio
What you need: Income Statement
The formula: Interest Coverage Ratio = EBIT / Interest Expense
What it means: Both EBIT (aka, operating income) and interest expense are found on the income
statement. The interest coverage ratio, also known as times interest earned (TIE), is a measure
of how well a company can meet its interest payment obligations. If a company can't make
enough to make interest payments, it will be forced into bankruptcy. Anything lower than 1.0 is
usually a sign of trouble.

Efficiency Ratios
These ratios give investors insight into how efficiently a business is employing resources
invested infixed assets and working capital. It's can also be a reflection of how effective a
company's management is.
14) Asset Turnover Ratio
What you need: Income Statement, Balance Sheet
The formula: Asset Turnover Ratio = Sales / Average Total Assets
What it means: Like return on assets (ROA), the asset turnover ratio tells you how good the
company is at using its assets to make products to sell. For example, if Company A reported
$100,000 of sales and owns $50,000 in assets, its asset turnover ratio is 2x. For ever $1 of
assets it owns, it can generate $2 in sales each year.
15) Inventory Turnover Ratio
What you need: Income Statement, Balance Sheet
The formula: Inventory Turnover Ratio = Costs of Goods Sold / Average Inventory

What it means: If the company you're analyzing holds has inventory, you want that company to
be selling it as fast as possible, not stockpiling it. The inventory turnover ratio measures this
efficiency in cycling inventory. By dividing costs of goods sold (COGS) by the average amount of
inventory the company held during the period, you can discern how fast the company has to
replenish its shelves. Generally, a high inventory turnover ratio indicates that the firm is selling
inventory (thereby having to spend money to make new inventory) relatively quickly.

Assets Utilization Ratios

Asset Utilization Assets utilization (activity, turnover) ratios reflects the way in which a company
uses its assets to obtain revenue and profit. One example is how well receivables are turning into
cash. The higher the ratio, the more efficiently the business manages its assets.
Accounts receivable ratios comprise the accounts receivable turnover and the average collection
period.
The accounts receivable turnover provides the number of times accounts receivable are collected
in the year. Dividing net credit sales by average accounts receivable produces the accounts
receivable turnover. One can calculate average accounts receivable by the average accounts
receivable balance during a period.
Net credit sales
Accounts receivable turnover =
Average accounts receivable
The average collection period, also called days sales outstanding (DSO), is the length of time it
takes to collect receivables. It represents the number of days receivables are held.
365 days
Average collection period =
Accounts receivable turnover
Inventory ratios are useful, especially when a buildup in inventory exists. Inventory ties up cash.
Holding large amounts of inventory can result in lost opportunities for profit as well as increased
storage costs. Before extending credit or lending money, one should examine the firm's inventory
turnover and average age of inventory.
Costs of goods sold
Inventory turnover =
Average inventory

365
Average age of inventory =
Inventory turnover
The operating cycle is the number of days its takes to convert inventory and receivables to cash.

Operating cycle = Average collection period + Average age of inventory

By calculating the total assets turnover, one can find out whether the company is efficiently
employing its total assets to obtain sales revenue. A low ratio may indicate too high an investment
in assets in comparison to the sales generated.
Net sales
Total assets turnover =
Average total assets

Solvency Ratios
Solvency (Leverage and Debt Service)
Solvency is the company's ability to satisfy long-term debt as it becomes due. One should be
concerned about the long-term financial and operating structure of any firm in which one might be
interested. Another important consideration is the size of the debt in the firm's capital structured
referred to a financial leverage. (Capital structure is the mix of the long-term sources of funds
used by the firm).
Solvency also depends on earning power; in the long run, a company will not satisfy its debts
unless it earns profit. A leveraged capital structure subjects the company to fixed interest charges,
which contributes to earnings instability. Excessive debt may also make it difficult for the firm to
borrow funds at reasonable rates during tight money markets.
The debt ratio reveals the amount of money a company owes to its creditors. Excessive debt
means greater risk to the investor. The debt ratio is:
Total liabilities
Debt ratio =
Total assets
The debt-equity ratio will show if the firm has a great amount of debt in its capital structure. Large
debts mean that the borrower has to pay significant periodic interest and principal. Also, a heavily
indebted firm takes a greater risk of running out of cash in difficult times. The interpretation of this
ratio depends on several variables, including the ratios of other firms in the industry, the degree of
access to additional debt financing, and stability of operations.
Total liabilities
Debt-equity ratio =
Stockholder's equity
Times interest earned (interest coverage ratio) tells how many times the firm's before-tax earnings
would cover interest. It is a safety margin indicator in that it reflects how much of a reduction in
earnings a company can tolerate.
Income before interest and taxes
Times interest earned =
Interest expense
One must also note liabilities that have not yet been reported in the balance sheet by closely
examining footnote disclosure. For example, one should find out about lawsuits, noncapitalized
leases, and future guarantees

.) Why are ratios useful? What are the five major categories of ratios?Ratios are important because
it enables the business owner and managers to detect trendsin the company and to compare its
performance and condition with the average performance of
similar businesses in the same industry. Ratios also helps us identify and quantify a companys
strengths and weaknesses, evaluate its financial position, and understand the risks involved in the
company. Ratio can help managers implement plans that improve a companys profitability,
liquidity and financial structure.The five major categories of ratios are; Liquidity Ratios, Asset
Management Ratios, DebtManagement Ratios, Profitability Ratios and Market Value Ratios.
b.) Calculate Everelites 2009 current and quick ratios
based on the projected balance sheet andincome statement data. What can you say about the
companys liquidity positions in 2007, in
2008, and as proje
cted for 2009? We often think of ratios as being useful (1) to managers help
run the business. (2) to bankers for credit analysis and (3) to stockholders for stock valuation.
Would these different types of analysts have an equal interest in the companys
liquidity ratios?

In 2007, Everelites current ratio is slightly below the industry average. However, its
quick ratio is higher compared to the industry average. Thus, the firm can pay their currentliabilities
if they will not rely on the sale of their inventories.In 2008, as shown in its liquidity ratios, both
below the industry average, Everelite, couldnot be able to meet its short term debts.
In 2009, both current and quick ratios increased relative to last years. However, current
ratio is lower than the industry average by .2 while its quick ratio levels the industry average.This
means that basing solely from the current and quick ratios, improvement is expected but itis safe to
say that the liquidity position of the firm is weak.No, they don't have an equal interest in the liquidity
ratio. The following are the specificreasons:
MANAGER:Some of the most basic financial ratios show how much a business or investment
willreturn compared to how much it will cost. When managers are planning new projects,
thesefinancial ratios provide the support they need to receive funding from executives to
moveforward. Executives like to see a high return on investment, or ROI, based on analysis of
costsand projected revenues. After projects are completed, the same type of analysis can show
thereturns actually delivered, and how the investment lived up to expectations, which is useful
forfuture strategy

CREDIT ANALYST:Credit analysts will be particularly interested in the applicant's liquidity and ability
to paybills on time. Such ratios as the quick ratio, receivables, inventory turnovers, the average
payableperiod and debt-to-equity ratio are particularly relevant. In addition to analyzing
financialstatements, the credit analyst will consider the character of the company and its
management, thefinancial strength of the firm, and various other
matters.STOCKHOLDERS:Interested only in Return On Equity (ROE), Dividend Rate, Gross Margin,
Net IncomeMargin and Quarterly and Annual Growth Ratios.In general, Financial Statement Analysis
is used by: a) managers to evaluate and improveperformance, b) lenders (banks and bondholders)
and bond rating analysts (SP and Moody's) toevaluate the creditworthiness of a company, and c)
stockholders (current or prospective) andstock analysts, to forecast earnings, DIV and stock
price." The five types of ratios are liquidity,asset management, debt management, profitability, and
market value ratios.
c.) Calculate the 2009 inventory turnover, days sales outstanding (DSO), fixed assets turnover,
and total assets turnover. How does Everelites utilization of assets stack up against other firms in
the industry?
Inventory turnover is below the industry average and is getting worse, maybe becausethey have old
inventories or its control might be poor. No improvement is currently forecasted(In fact, the
opposite). The firm collects its receivables too slowly (2007: 135.60 days, 2008:108.32 days. 2009:
154. 69 days) as compared to the 56 days norm. This suggests the
managements poor credit policy. The companys fixed assets turnover declines with time, and is
expected to go way lower than the industry average. This shows that it does not use its long
termassets effectively so as to generate higher sales. Total assets turnover is not in line with
othercompanies in the same industry. As time passes by, it continues to turn down. This is caused
byexcessive current assets (Accounts Receivable/Inventory) To sum up; Everelite is inefficientlyusing
its assets.
d.) Calculate the 2009 debt and times-interest-earned ratios. How does Everelite compare withthe
industry with respect to financial leverage? What can you conclude from these ratios?
As compared to the industry average, Everelite's financial leverage is relatively higherwhich means
that a large fraction of their assets are primarily financed by the creditors. Since thecompany uses
great financial leverage, it is subject to higher risks.
e.) Calculate the 2009 operating margin, profit margin, basic earning power (BEP), return onassets
(ROA), and return on equity (ROE). What can you say about these ratios?
It may be recalled that the profitability ratios bring together the asset and debtmanagement ratios
and show their effects on
ROE. Though Everelites operating margin, profit
margin, basic earning power and return on assets have shown improvements compared to last

years, still, they are way lower than the industry average. This implies the firms poor utilization
of assets. However, its ROE is above the industry norm. This may be attributed to the use of
toomuch leverage which exposes the firm to a higher risk. Using leverage does not guarantee the
firms good results of operations. In Everelites case, the use of leverage leave
s the firm in anear-to-bankruptcy position.
f.) Calculate the 2009 price/earnings ratio and market/book ratio. Do these ratios indicate
thatinvestors are expected to have a high or low opinion of the company?
Both the P/E and M/B ratio are above the industry norm. A stock with a high P/E ratiosuggests that
investors are expecting higher earnings growth in the future compared to the overallmarket, as
investors are paying more for today's earnings in anticipation of future earningsgrowth. Hence, as a
generalization, stocks with this characteristic are considered to begrowthstocks.Thegrowth
investorviews high P/E ratio stocks as attractive buys and low P/E stocks asflawed, unattractive
prospects
On the other hand, the firms high P/B ratio is often a sign that a business has rosierfuture prospects
than past performance. Share price is high relative to book value becauseinvestors have bid up the
share price based on expectations of better earnings and/or cash flowahead.
g.) Usethe DuPont equation to provide a summary and overview of Everelites financialcondition as
projected for 2009. What are the firms major strengths and weaknesses?
Strengths: The firms ROE shows a great increase. This indicates that managers did an
effectiveutilization of the resources given by stockholder by generating profits that will result to an
accretion of the investors equity.
Weaknesses: The firms liquidity position is weak;all its asset management ratios are poor); itsdebt
management ratios are poor and most of its profitability ratios are low (except return onequity). The
company is currently achieving low productivity from its inventory and fixed assets.It is also
not collecting from its customers as quickly as the industry. It needs to improve itssales and/or
reduce inventories and fixed assets to better match its competitors.
h.) Use the following simplified 2009 balance sheet to show, in general terms, how animprovement
in the DSO would tend to affect the stock price. For example, if the company couldimprove its
collection procedures and thereby lower its DSO without affecting sales, how would that change
ripple through the financial statements (shown in thousands below) and influencethe stock price?
Reducing Accounts Receivable will have no effect on sales.
Initially shows up as addition to cash.Effect of reducing receivables on balance sheet and stock price.
Improving the
companys collection procedures without affecting sales by lowering its DSO

from 154. 69 days to the 56 days industry average would result to an addition to cash. The freedup
cash could be utilized to repurchase stock, expand the business, and reduce debt. All of theseactions
would likely improve the stock price.
i.)

Does it appear that inventories could be adjusted? If so, how should that adjustment
affectEverelite's profitability and stock price?
The inventory turnover ratio is low. It appears that the firm either has excessive
inventoryor some of the inventory is obsolete. If inventory were reduced, this would
improve the current asset ratio, the inventory and total assets turnover, and reduce the
debt ratio even further, whichshould improve the firms stock price and profitability.

j.) In 2008, the company paid its suppliers much later than the due dates; also, it was notmaintainin
g financial ratios at levels called for in its bank loan agreements. Therefore, supplierscould cut the
company off, and its bank could refuse to renew the loan when it comes due in 90days. On the basis
of data provided, would you, as a credit manager, continue to sell to Evereliteon credit? (You could
demand cash on delivery that is, sell on terms of COD but that mightcause Everelite to stop
buying from your company.) Similarly, if you were the bank loan officer,would you recommend
renewing the loan or demand its repayment?
With reference to the ratios such as quick, receivable and inventory turnover which showthe
company's inability to pay off its' debts when they fall due. As a credit manager, it isunfavorable to
continue providing supplying a portion of its total funds with its currentarrangement. Terms of COD
might be a little harsh and might push the firm into bankruptcy.Likewise, if the bank demanded
repayment this could also force Everelite intobankruptcy. Therefore, renewing the loan is a
preferable option
.k.) What are some potential problems and limitations of financial ratio analysis?
Many ratios are calculated on the basis of the balance-sheet figures. These figures are ason the
balance-sheet date only and may not be indicative of the year-round position. Comparingthe ratios
with past trends and with competitors may not give a correct picture as the figures maynot be easily
comparable due to the difference in accounting policies, accounting period etc. Itgives current and
past trends, but not future trends. Impact of inflation is not properly reflected,as many figures are
taken at historical numbers, several years old. There are differences in approach among financial
analysts on how to treat certain items, how to interpret ratios etc. Theratios are only as good or bad
as the underlying information used to calculate them.Although ratio analysis is very important tool
to judge the company's performance, following arethe limitations of it. Seasonal factors can distort
ratios, Window dressing techniquescan make statements and ratios look better. Different operating
and accounting practices distortcomparisons.Sometimes, it is hard to tell if ratio is good or bad.
l.) What are some qualitative factors that analysts should consider when evaluating a
company'slikely future financial performance?
The following are some qualitative factors that analysts should consider:1.)To what extent are the
company's revenues tied to one key customer or to one keyproduct? To what extent does the
company rely on a single supplier? Reliance on singlecustomers, products, or suppliers increases risk.

2.)What percentage of the company company's business is generated overseas? Companieswith a

large percentage of overseas business are exposed to risk of currency exchange volatilityand
political instability.
3.)What are the probable actions of current competitors and the likelihood of additional
newcompetitors?
4.)Do the company's future prospects depend critically on the success of the productscurrently in
the pipeline or on existing products?
5.)How does the legal and regulatory environment affect the company?