Liquidity and solvency ratios: can the company pay?

What do liquidity ratios tell you?

Whether the company can meet its short-term obligations. Liquidity ratios compare assets that turn into cash soon with bills due soon. They describe a position at one date, so they use year-end balances, not averages.

The current ratio counts all current assets. The quick ratio keeps only cash, short-term investments and receivables, because inventory and prepaid expenses are slow or impossible to turn into cash quickly. The cash ratio is stricter still and is the best crisis measure.

Memorize

$$\text{Current ratio} = \frac{\text{current assets}}{\text{current liabilities}}$$

$$\text{Quick ratio} = \frac{\text{cash} + \text{short-term investments} + \text{receivables}}{\text{current liabilities}}$$

$$\text{Cash ratio} = \frac{\text{cash} + \text{short-term investments}}{\text{current liabilities}}$$

The defensive interval ratio takes a different view: how many days could the company keep paying its cash costs from its liquid assets if no cash came in? Estimate daily cash expenditures from the income statement by adding the operating expenses and removing non-cash items such as depreciation. Taxes are normally left out too.

$$\text{DIR} = \frac{\text{cash} + \text{short-term investments} + \text{receivables}}{\text{daily cash expenditures}}$$

What do solvency ratios measure?

The ability to meet long-term obligations. Solvency ratios come in two kinds. Debt ratios look at the balance sheet and show how much of the financing is debt. Coverage ratios look at the income statement and show whether earnings can pay for that debt.

For these ratios, total debt means interest-bearing short-term and long-term borrowings. It excludes accounts payable and accruals (and, by the convention the exam uses, leases). Always check how a question defines debt. Net debt subtracts cash, cash equivalents and marketable securities, on the logic that they could repay debt.

Memorize

$$\text{Debt-to-assets} = \frac{\text{total debt}}{\text{total assets}}$$

$$\text{Debt-to-capital} = \frac{\text{total debt}}{\text{total debt} + \text{total equity}}$$

$$\text{Debt-to-equity} = \frac{\text{total debt}}{\text{total equity}}$$

$$\text{Financial leverage} = \frac{\text{average total assets}}{\text{average total equity}}$$

The financial leverage ratio shows how many units of assets each unit of equity supports. It is built from averages here because it feeds DuPont analysis; in practice, year-end figures are also used. The first three ratios are the debt-to-assets ratio , the debt-to-capital ratio and the debt-to-equity ratio . Higher values of all of them mean more financial risk.

$$\text{Net debt} = \text{total debt} - \text{cash} - \text{marketable securities}$$

$$\text{Debt-to-EBITDA} = \frac{\text{total (or net) debt}}{\text{EBITDA}}$$

Net debt is what remains after liquid assets are set against borrowings. Debt-to-EBITDA estimates how many years of EBITDA, a rough proxy for operating cash flow, it would take to repay debt, and it is common in loan covenants.

How do coverage ratios work?

They count how many times earnings pay the fixed cost of the debt.

$$\text{Interest coverage} = \frac{\text{EBIT}}{\text{interest payments}}$$

$$\text{Fixed charge coverage} = \frac{\text{EBIT} + \text{lease payments}}{\text{interest payments} + \text{lease payments}}$$

Interest coverage (“times interest earned”) covers interest alone. Fixed charge coverage also includes lease payments: they were deducted in arriving at earnings before interest and taxes (EBIT), so they go back on top, and they are a fixed charge, so they join the bottom. A higher ratio means a safer cushion, and fixed charge coverage is also used to judge how safe a preferred dividend is.

Worked example: Sandmere Retail

Year-end balance sheet (USD m): cash 500, marketable securities 100, receivables 1,100, inventory 1,300, current assets 3,000, total assets 8,000, current liabilities 1,600, short-term debt 400, long-term debt 2,800, equity 3,600. Total assets and equity were 7,000 and 3,000 at the start of the year. Income statement: revenue 12,000, cost of sales 7,200, selling, general, and administrative expenses (SG&A, cash) 3,000, depreciation 400, EBIT 1,400, interest 200, lease payments 100.

How do transactions move the ratios?

Start from Sandmere’s year-end numbers and apply one event at a time.

Event	Current	Quick	Cash	Debt-to-assets	Debt-to-equity
Base	1.88	1.06	0.38	0.40	0.89
Pay a supplier 200 in cash	2.00	1.07	0.29	0.41	0.89
Issue 500 of long-term debt for cash	2.19	1.38	0.69	0.44	1.03
Buy 300 of inventory on credit	1.74	0.89	0.32	0.39	0.89
Repay 400 of short-term debt with cash	2.17	1.08	0.17	0.37	0.78

Notice two patterns. Raising long-term debt improves every liquidity ratio and worsens every solvency ratio, which is why liquidity asks about next year while solvency asks about the whole capital structure. And paying a bill with cash lifts the current ratio but lowers the cash ratio, because the cash ratio’s numerator shrinks proportionally more.

Can the company pay?

• Liquidity Memorize next year's bills
  • Current ratio all current assets
  • Quick ratio cash, investments, receivables
  • Cash ratio cash and investments
  • Defensive interval days of cash expenses covered
• Solvency Memorize the whole capital structure
  • Debt ratios balance sheet
    • Debt-to-assets
    • Debt-to-capital
    • Debt-to-equity
    • Financial leverageaverage assets ÷ average equity
    • Debt-to-EBITDAyears of EBITDA to repay debt
  • Coverage ratios income statement
    • Interest coverageEBIT ÷ interest
    • Fixed charge coverageadds lease payments

Exam tip A “what happens to the ratio” question: write the ratio, adjust top and bottom for the event, then compare against 1 before you decide the direction.

Go deeper Operating leverage and the amount of debt a company can carry

The more a company’s operating income swings with sales (high operating leverage), the less debt it can safely add. A steady business such as a regulated utility can carry high debt ratios with little risk of missing payments, while a cyclical business with the same ratios is far riskier. This is why analysts read solvency ratios against the stability of cash flows and not as absolute targets.

Go deeper Why fixed charge coverage still matters when leases are on the balance sheet

Lessees now put most leases on the balance sheet as liabilities, so a debt ratio can include lease liabilities if the analyst chooses. Lease payments are still a contractual cash call every period. Fixed charge coverage captures that call whichever way the balance sheet treats the lease, and it keeps lease-heavy companies comparable with those that own their assets. Credit analysts also adjust for pension deficits and other debt-like items.