Financial Strength and Ratio Analysis

Current Ratios and Quick Ratios

Current ratios help evaluate a company’s ability to pay short-term obligations.

Current ratio = current assets / current liabilities

The current ratio includes all current assets, but since inventory is not always quickly liquidated, many analysts remove it from the equation and use the Quick ratio.

Quick ratio = (current assets – inventory) / current liabilities

The quick ratio emphasizes assets that are easily converted to cash.  The higher the ratio, the better off the company.  Analysts like to see ratios greater than 2:1 for current ratios and 1:1 for quick ratios.

Debt to Equity and Debt to Total Assets

Debt to equity and debt to assets represent a firm’s solvency or leverage.  These ratios measure what portion of a firm’s assets are provided by the owners and what portion are provided by others.  Too much long-term debt costs money and increases risk. 

Debt to equity = total debt / owners equity

(current liabilities such as accounts payable are not typically used)

Debt to total assets = total dept / total assets

Companies that have more debt than assets raise flags to credit analysts, but industry comparisons will play an important role in the overall decision making process.

Cash Flow Ratios

Cash is the lifeblood of any business.  Typically, financial strength is measured by cash flow ratios.  The overall cash flow of any business tells whether that business is generating what it needs to sustain, grow and return capital to owners.

Overall Cash Flow ratio = cash inflow from operations / (investing cash outflows + financing cash outflows)

If the cash outflow ratio is greater than 1, the firm is generating enough cash to cover business needs, but if its less than 1, the company needs to find alternative ways to access capital to stay afloat.

When cash flows are equal to, or exceed earnings, your company is in good shape.  If earnings increase, but your cash flow doesn’t, you have to question the quality of the earnings.  The best measure of earnings quality is the cash flow to earnings ratio.

Cash Flow to earnings = cash flow from operations / net earnings

There is no real measure on this ratio because there are different variables depending on industry.  However, rule of thumb is that increases in earnings at the same rate as increase in cash flow are a good thing.