Liquidity Ratios

Liquidity Ratios
Liquidity Ratios
It measures the ability of a company to pay maturing obligations from its
current assets.
Important:
Current Asset – Cash and other assets which one are expected to be
converted into cash within 12 months.
Current Liabilities – Obligations that are expected to be settled or paid

within 12 months.
Liquidity Ratios
• Current Ratio
• Acid Test Ratio
Current ratio
Current Assets ÷ Current Liabilities
Current ratio
The Current Ratio of ___ means that for every P1.00
of current liabilities, it has ___ current asset.
ACID Test ratio
(Current Assets – Inventories) ÷ Current Liabilities
Leverage Ratios
It shows the capital structure of a company, that is, how much
of the total assets of a company is financed by debt and how
much is financed by stockholders’ equity. It can also be used to
measure the company’s ability to meet long-term obligations.
Nature of business
If a company is in risky business and operating cash flows are uncertain
like mining operations, it has to be more conservatively financed.
Conservative financing means there should be more stockholders’ Equity.
If the business is characterized by stable operating cash flows like what is

true for SM malls where cash flows from rent are almost certain, then a
more aggressive capital structure can be considered. Stable operating
cash flows allow the company to pay periodic debt amortizations.
Stage of business
development
A company which is just starting its operations may encounter difficulties
in borrowing from banks.
Banks generally look for the historical performance of a company in

making decisions regarding loan applications. A new company does not
have that historical record.
Stage of business
development
A company which is just starting its operations may encounter difficulties in
borrowing from banks.
Banks generally look for the historical performance of a company in making

decisions regarding loan applications. A new company does not have that
historical record.
It is not good to start a business with borrowed funds.

Macroeconomic
conditions
If macroeconomic conditions are good as measured by Gross
Domestic Product (GDP) and this trend is expected to
continue in the foreseeable future, then management can
take a more aggressive stance in financing the company’s
operations to take advantage of the opportunities.
Prospects of the
industry and expected
growth rates
If the industry where the company operates has good
prospects and growth rates are expected to be high,
management can consider borrowing more to expand
operations. Otherwise, if the prospects are bleak, it is better
to have low debt ratios.
Bond and stock
market conditions
The ability of a company to raise more funds from stock market
and bond market also depends on how strong players are in these
markets. If both markets are doing well just like what the
Philippines has been experiencing over the last couple of years
where its stock market and bond market are both expanding,
then it is a good opportunity to tap both markets.
Financial Flexibility
The ability of a company to raise funds, be it the stock market
or the bond market, when the need for cash arises.
Companies which have low leverage ratios have more

financial flexibility as compared to companies which have
higher leverage ratios.
Regulatory environment
These are operations which are heavily regulated such as
banks which are monitored by the BSP. Banks, as required by
BSP, have to maintain a minimum level of capital adequacy
ratio, a kind of leverage ratio applied to banks.
Taxes
Interest expense are allowed to be deducted from operating
income to compute taxable income. Therefore, interest
expense reduce tax payments.
Cash dividends are not allowed to be deducted from the

operating income in computing taxable income. Hence, there
are no tax shields from cash dividend payments.
Management style
Some managers are aggressive and some managers are
conservative.
Management style definitely contributes to the kind of capital

structure a company has. Management recommends to the
Board of Directors the major financing activities a company
will embrace.
Leverage Ratios
• Debt Ratio
• Debt to Equity ratio
• Interest Coverage ratio
Debt ratio
It measures how much of the total assets are financed by liabilities.
Debt Ratio = Total Liabilities ÷ Total Assets

Debt ratio
The debt ratio of less than 0.50 means that the company has
less liabilities as compared to its stockholders’ Equity.
If the debt ratio is 0.50, this means that the amount of total
liabilities is exactly equal to Stockholders’ Equity.
Debt to Equity ratio
Debt to Equity ratio is a variation of the debt ratio. A debt to
equity ratio of more than one means that a company has more
liabilities as compared to stockholders’ equity.
Debt to Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity

Interest coverage ratio
Interest coverage ratio provides information if the company
has enough operating income to cover interest expense.
Interest Coverage Ratio = Operating Income ÷ Interest Expense

Interest coverage ratio
The interest coverage ratio of ___ means that
____________________ has more than enough income or
earnings before interest and taxes to cover its interest
expense.
Efficiency Ratio or
Turnover Ratio
They measure the management’s efficiency in utilizing the
assets of the company.
Efficiency Ratio or
Turnover Ratio
• Total Asset turnover ratio
• Fixed Asset turnover ratio
• Accounts receivable turnover ratio
• Inventory turnover ratio
• Accounts payable turnover ratio
Total Asset turnover ratio
Total asset turnover ratio measures the ability to generate revenues
for every peso of asset invested. It is an indicator of how productive
the company is in utilizing its resources.
Asset Turnover ratio = Sales ÷ Total Assets

Total Asset turnover ratio
The asset turnover ratio of ____ means that for every
P1.00 of asset the company has in 2014, it is able to
generate sales of P____.
Fixed Asset Turnover ratio
If a company is heavily invested in Property, Plant and
Equipment (PPE) or Fixed Assets, it pays to know how efficient
the management of these assets are.
Fixed Asset Turnover ratio = Sales ÷ PPE

Fixed Asset Turnover ratio
The company was able to generate P____ for every P1.00
of PPE that it has.
Accounts Receivable
Turnover ratio
The efficiency by which accounts receivable are managed. A high
accounts receivable turnover ratio means efficient management of
receivables.
Accounts Receivable turnover ratio = Sales ÷ Accounts Receivable

Accounts Receivable
Turnover ratio
The company had an average ____ days collecting its
accounts receivable. This means that from the day the sale
was made, it took the company ____ on the average, to
collect its accounts receivable.
Inventory Turnover ratio
It measures the company’s efficiency in managing its inventories.
Trading and manufacturing companies and companies that are dealing with
highly perishable products and those that are prone to technological
obsolescence must pay close attention to this ratio to minimize loses.
Inventory Turnover ratio = Cost of Sales ÷ Inventories

Inventory Turnover ratio
This ___ days’ inventories means that the company took
___ days, on the average, to sell its inventories from the
time they were bought.
Accounts Payable turnover
ratio
Provides the information regarding the rate by which trade payables are
paid.
Any operating company will prefer to have a longer payment period for its
accounts payable but this should be done only with the concurrence of
the suppliers.
Accounts Payable Turnover ratio = Cost of Sales ÷ Trade Accounts Payable

Accounts Payable turnover
ratio
This number suggests that the average payment period of
the company for its trade accounts payable was ___ days.
Operating Cycle and Cash
Conversion Cycle
Operating Cycle
By adding the average collection period and days’ inventories, the
operating cycle can be computed.
This operating cycle covers the period from the time the merchandise
is bought to the time the proceeds from the sale are collected.
Operating Cycle = Days’ Inventory + Days’ receivable

Cash Conversion Cycle
It measures how long it took the company to collect
receivables from the time the cost of the merchandise sold
was actually paid.
Cash Conversion cycle = Operating cycle – Days’ Payable

Liquidity Ratios

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Liquidity Ratios

Current Liabilities – Obligations that are expected to be settled or paid

If the business is characterized by stable operating cash flows like what is

Banks generally look for the historical performance of a company in

Banks generally look for the historical performance of a company in making

It is not good to start a business with borrowed funds.

Companies which have low leverage ratios have more

Cash dividends are not allowed to be deducted from the

Management style definitely contributes to the kind of capital

Debt Ratio = Total Liabilities ÷ Total Assets

Debt to Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity

Interest Coverage Ratio = Operating Income ÷ Interest Expense

Asset Turnover ratio = Sales ÷ Total Assets

Fixed Asset Turnover ratio = Sales ÷ PPE

Accounts Receivable turnover ratio = Sales ÷ Accounts Receivable

Inventory Turnover ratio = Cost of Sales ÷ Inventories

Accounts Payable Turnover ratio = Cost of Sales ÷ Trade Accounts Payable

Operating Cycle = Days’ Inventory + Days’ receivable

Cash Conversion cycle = Operating cycle – Days’ Payable

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