Chapter 1 - Liquidity, Solvency and Leverage Ratios
● Vertical analysis-
On an income statement, sales is valued at 100%. All other amounts are a percentage of
sales.
On the balance sheet, total assets are 100%, as is the total of liabilities and
stockholders’ equity. Each line item can be interpreted in terms of its proportion of the
baseline figure.
● Horizontal analysis-
It states the amounts for several periods as percentages of a base-year amount. These
are often called trend percentages.
One period is designated the base period, to which the other periods are compared.
Each line item of the base period is thus 100%.
● Liquidity - firm’s ability to pay its current obligations as they come due and thus remain in
business in the short run. Liquidity reflects the ease with which assets can be converted to
cash. Short term focus.
● Current assets are the most liquid. They are expected to be converted to cash, sold, or
consumed within 1 year or the operating cycle, whichever is longer.
● Current liabilities are ones that must be settled the soonest. Specifically, they are expected
to be settled or converted to other liabilities within 1 year or the operating cycle, whichever
is longer.
● CA- cash, receivables, marketable securities, inventories, prepaid items
● CL- accounts payable, notes payable, unearned revenues, tax payables, wages payable
etc
● net working capital is CA - CL
● Current ratio: CA/CL
A low ratio indicates a possible solvency problem. A firm with a low current ratio may
become insolvent.
An overly high ratio indicates that management may not be investing idle assets
productively.
The general principle is that the current ratio should be proportional to the operating
cycle. Thus, a shorter cycle may justify a lower ratio.
Acid ratio: cash + marketable secs + net accounts receivable / CL
more conservative than current ratio
, doesn't take into account inventories because what if we can't sell the inventories in this
current period?
This ratio measures the firm’s ability to easily pay its short-term debts and avoids the
problem of inventory valuation.
Cash ratio: cash + marketable secs / CL
Cash flow ratio: cash flow from operations/ CL
Net WC ratio: WC/Total Assets
Solvency refers to the ability of a business to meet its long-term obligations. This ability is
related to the extent to which the business uses debt versus equity financing.
capital structure: debt and equity; total debt is total liabilities
a company with a higher percent of debt capital will be riskier than a firm with a high
percentage of equity capital. Thus, when there is a lot of debt, equity investors will demand
a higher rate of return on their investments to compensate for the risk brought about by the
high use of financial leverage.
Alternatively, a company with a high level of equity capital will be able to borrow at lower
rates because debt holders will accept lower interest in exchange for the lower risk
indicated by the equity cushion.
The following are advantages of debt to the issuer:
Interest paid on debt is tax deductible.
Control of the firm is not shared with debtholders.
The following are disadvantages of debt to the issuer:
Unlike returns on equity investments, the payment of interest and principal on debt
is a legal obligation.
The legal requirement to pay interest and principal increases a firm’s risk and
reduces its retained earnings. Because shareholders demand increased retained
earnings, they are less likely to invest in the firm, thus decreasing the share price.
Debt may require collateral, specific property pledged to a lender in case of default.
The following are advantages of equity to the corporation:
Common stock does not require a fixed dividend. Dividends are paid from profits
when available.
Common stock has no fixed maturity date for repayment of capital.
, The sale of common stock increases the creditworthiness of the firm by providing
more capital (or money) for the corporation.
The following are disadvantages of equity to the corporation:
Cash dividends on common stock are not tax-deductible and are paid from after-tax
profits.
New common stock sales dilute earnings per share (EPS) available to current
shareholders.
Too much equity may raise the average cost of capital of the firm above its optimal
level.
total debt to total capital = total liabilities/total capital
When total debt to total capital is low, the firm’s capital is supplied by the
shareholders. Thus, creditors prefer this ratio to be low as a cushion against losses.
debt to equity = Total debt/Stockholders equity
The debt to equity ratio reflects long-term debt-payment ability. Again, a low ratio
means a lower relative debt burden and thus better chances of repayment of
creditors.
long-term debt to equity = NCL/Stockholders equity
A low ratio means a firm will have an easier time raising new debt (since its low
current debt load makes it a good credit risk).
Debt to total assets ratio = Total liabilities/Total assets
Numerically, this ratio is identical to the debt to total capital ratio.
● Times interest earned ratio= EBIT/interest expense
, HIGHER IS GOOD Earnings coverage ratios are a creditor’s best measure of a
firm’s ongoing ability to generate the earnings that will allow it to service debt.
The times interest earned ratio is an income statement approach to evaluating a
firm’s ongoing ability to meet the interest payments on its debt obligations.
Earnings to fixed charges ratio = earnings before fixed charges and taxes/fixed
charges
Fixed charges include interest, required principal repayments, and leases.
This is a more conservative ratio since it measures the coverage of earnings over all
fixed charges, not just interest expense.
● Leverage is the relative amount of fixed cost in a firm’s overall cost structure. Leverage
creates risk because fixed costs must be covered, regardless of the level of sales.
● Operating leverage arises from the use of a high level of plant and machinery in the
production process, revealed through charges for depreciation, property taxes, etc.
● degree of operating leverage = cont margin/operating income or EBIT
OR
% change in EBIT or OI / % change in sales
● higher operating leverage, more risk, more reward.
● changes in sales will cause a change in earnings.
● Vertical analysis-
On an income statement, sales is valued at 100%. All other amounts are a percentage of
sales.
On the balance sheet, total assets are 100%, as is the total of liabilities and
stockholders’ equity. Each line item can be interpreted in terms of its proportion of the
baseline figure.
● Horizontal analysis-
It states the amounts for several periods as percentages of a base-year amount. These
are often called trend percentages.
One period is designated the base period, to which the other periods are compared.
Each line item of the base period is thus 100%.
● Liquidity - firm’s ability to pay its current obligations as they come due and thus remain in
business in the short run. Liquidity reflects the ease with which assets can be converted to
cash. Short term focus.
● Current assets are the most liquid. They are expected to be converted to cash, sold, or
consumed within 1 year or the operating cycle, whichever is longer.
● Current liabilities are ones that must be settled the soonest. Specifically, they are expected
to be settled or converted to other liabilities within 1 year or the operating cycle, whichever
is longer.
● CA- cash, receivables, marketable securities, inventories, prepaid items
● CL- accounts payable, notes payable, unearned revenues, tax payables, wages payable
etc
● net working capital is CA - CL
● Current ratio: CA/CL
A low ratio indicates a possible solvency problem. A firm with a low current ratio may
become insolvent.
An overly high ratio indicates that management may not be investing idle assets
productively.
The general principle is that the current ratio should be proportional to the operating
cycle. Thus, a shorter cycle may justify a lower ratio.
Acid ratio: cash + marketable secs + net accounts receivable / CL
more conservative than current ratio
, doesn't take into account inventories because what if we can't sell the inventories in this
current period?
This ratio measures the firm’s ability to easily pay its short-term debts and avoids the
problem of inventory valuation.
Cash ratio: cash + marketable secs / CL
Cash flow ratio: cash flow from operations/ CL
Net WC ratio: WC/Total Assets
Solvency refers to the ability of a business to meet its long-term obligations. This ability is
related to the extent to which the business uses debt versus equity financing.
capital structure: debt and equity; total debt is total liabilities
a company with a higher percent of debt capital will be riskier than a firm with a high
percentage of equity capital. Thus, when there is a lot of debt, equity investors will demand
a higher rate of return on their investments to compensate for the risk brought about by the
high use of financial leverage.
Alternatively, a company with a high level of equity capital will be able to borrow at lower
rates because debt holders will accept lower interest in exchange for the lower risk
indicated by the equity cushion.
The following are advantages of debt to the issuer:
Interest paid on debt is tax deductible.
Control of the firm is not shared with debtholders.
The following are disadvantages of debt to the issuer:
Unlike returns on equity investments, the payment of interest and principal on debt
is a legal obligation.
The legal requirement to pay interest and principal increases a firm’s risk and
reduces its retained earnings. Because shareholders demand increased retained
earnings, they are less likely to invest in the firm, thus decreasing the share price.
Debt may require collateral, specific property pledged to a lender in case of default.
The following are advantages of equity to the corporation:
Common stock does not require a fixed dividend. Dividends are paid from profits
when available.
Common stock has no fixed maturity date for repayment of capital.
, The sale of common stock increases the creditworthiness of the firm by providing
more capital (or money) for the corporation.
The following are disadvantages of equity to the corporation:
Cash dividends on common stock are not tax-deductible and are paid from after-tax
profits.
New common stock sales dilute earnings per share (EPS) available to current
shareholders.
Too much equity may raise the average cost of capital of the firm above its optimal
level.
total debt to total capital = total liabilities/total capital
When total debt to total capital is low, the firm’s capital is supplied by the
shareholders. Thus, creditors prefer this ratio to be low as a cushion against losses.
debt to equity = Total debt/Stockholders equity
The debt to equity ratio reflects long-term debt-payment ability. Again, a low ratio
means a lower relative debt burden and thus better chances of repayment of
creditors.
long-term debt to equity = NCL/Stockholders equity
A low ratio means a firm will have an easier time raising new debt (since its low
current debt load makes it a good credit risk).
Debt to total assets ratio = Total liabilities/Total assets
Numerically, this ratio is identical to the debt to total capital ratio.
● Times interest earned ratio= EBIT/interest expense
, HIGHER IS GOOD Earnings coverage ratios are a creditor’s best measure of a
firm’s ongoing ability to generate the earnings that will allow it to service debt.
The times interest earned ratio is an income statement approach to evaluating a
firm’s ongoing ability to meet the interest payments on its debt obligations.
Earnings to fixed charges ratio = earnings before fixed charges and taxes/fixed
charges
Fixed charges include interest, required principal repayments, and leases.
This is a more conservative ratio since it measures the coverage of earnings over all
fixed charges, not just interest expense.
● Leverage is the relative amount of fixed cost in a firm’s overall cost structure. Leverage
creates risk because fixed costs must be covered, regardless of the level of sales.
● Operating leverage arises from the use of a high level of plant and machinery in the
production process, revealed through charges for depreciation, property taxes, etc.
● degree of operating leverage = cont margin/operating income or EBIT
OR
% change in EBIT or OI / % change in sales
● higher operating leverage, more risk, more reward.
● changes in sales will cause a change in earnings.
