Part 2: Basic Financial Ratios You Should Know
In Part 1, we looked at profitability ratios which focuses mainly on the financial performance of a company. But a company's financial performance is not always reflective of its full financial position. So on top of the profitability ratios, when investing in a company, you should also be aware of its financial standing through calculating liquidity and leverage ratios.
But something important to bear in mind is that these are just ratios… an in-depth analysis into the company would be a more prudent method to deciding whether you should invest in it or not. Either way, knowing these ratios can be helpful to give you a quick glance into a company’s financial health.
Liquidity ratios measure the ability of a company to meet its short term debt obligations. Two primary ratios are commonly used to assess liquidity: Current Ratio and Quick Ratio.
Current Ratio = Total Current Assets / Total Current Liabilities
Current Ratio measures the ratio of current assets to current liabilities. It is commonly used by lenders to determine whether a company has a sufficient level of liquidity to pay its short-term liabilities. When calculating the Current Ratio, it is important to ensure that the components under current assets are deemed collectible.
A higher ratio indicates that the company is more liquid. Generally, a Current Ratio of at least 2 is considered a good liquidity position but this number may vary from industry to industry. On the other hand, a Current Ratio that is too high may indicate that the company is not efficiently investing its current assets. A closer look at the components of current assets would reveal more.
Quick Ratio = (Cash & Cash Equivalents + Trade Receivables) / Total Current Liabilities
Quick Ratio measures the ratio of cash and trade receivables to current liabilities. It is a more stringent measure of a company’s liquidity position than Current Ratio as it excludes inventory and other current assets from the ratio. A higher ratio indicates that the company is more liquid. Generally, a Quick Ratio of at least 1 should be maintained for a good liquidity position.
Leverage ratios tell you how sustainable the financial position of a business is. They measure the ability of a company to meet its financial obligations, i.e. its debts. It shows you how leveraged a company is. There are two basic ratios you can use to assess financial leverage.
Debt Ratio = Total Liabilities / Total Assets
The Debt Ratio measures the leverage of a company. It tells you how much of a company’s assets are financed by liabilities. In general, the higher the Debt Ratio is, the more leveraged the company is and the greater the financial risk and exposure is.
Standards for Debt Ratio vary across industries and further benchmarking is needed to assess how high a Debt Ratio is considered high risk for the company. Capital-intensive industries tend to have a higher Debt Ratio. On the other hand, a Debt Ratio that is too low can mean that the company is not effectively reaping the benefits of leverage.
Debt/Equity Ratio = Total Liabilities / Total Shareholders’ Equity
The Debt/Equity Ratio indicates how much a company is financed by debt relative to equity. Generally, creditors prefer a lower Debt/Equity Ratio to decrease financial risk while investors prefer a higher ratio to realise the return benefits of financial leverage.
For a further look into financial ratios, look out for part 3 of this series.