A credit committee sees a target with rising revenue and a fat net margin, then passes anyway. The reason hides in the ratios: current assets barely cover current liabilities, net debt is four times earnings before interest, taxes, depreciation, and amortization (EBITDA), and interest coverage is slipping each year. Profit alone never tells you whether a company can pay its bills or survive its debt.
Liquidity measures short-term survival, the ability to cover obligations due within a year. Start with working capital, the raw cushion: current assets minus current liabilities. Positive working capital means current resources exceed near-term claims.
Turn that difference into a ratio. The current ratio (also called the working capital ratio) divides current assets by current liabilities. A value of 2.0 means $2 of current assets back every $1 due soon. The quick ratio (acid-test ratio) is stricter: it removes inventory, the slowest current asset to convert to cash.
Common mistakes
- Leaving inventory in the quick ratio. The quick (acid-test) ratio removes inventory. Using $600 / $300 = 2.0 instead of $350 / $300 = 1.17 overstates near-term liquidity.
- Forgetting to subtract cash for net debt. Net debt is total debt minus cash. Reporting $800 instead of $700 inflates net-debt/EBITDA and overstates leverage.
- Confusing debt-to-capital with debt-to-equity. Debt-to-capital puts debt in the denominator too, capping it at 1.0. Reporting 0.80 (the D/E) where 0.44 (D/capital) belongs doubles the apparent leverage.
Bottom line
- Current ratio = current assets / current liabilities; quick (acid-test) ratio strips out inventory; working capital = current assets − current liabilities
- Net debt = total debt − cash and equivalents; free cash flow yield = FCF / market cap (or per share / price)
- Cash conversion cycle = days sales outstanding + days inventory outstanding − days payables outstanding
- Leverage: debt-to-equity, debt-to-capital, debt-to-EBITDA, net debt/EBITDA; long-term variants count only long-term debt
Exam shortcut
Quick ratio is the current ratio minus inventory in the numerator. If both appear, the difference between them is purely the inventory share of current assets. DuPont in three words: profit, efficiency, leverage. ROE = net margin × asset turnover × equity multiplier. If asked why ROE moved, multiply the three and see which term changed. Coverage uses earnings flow; leverage uses debt stock.
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Learning objectives
- A3
- A4
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