A profitable company can run short of cash before its customers pay. Liquidity ratios, leverage ratios, and coverage ratios help you separate available liquidity, outstanding debt, and earnings available for interest before recommending financing.
When you assess a company's financing needs, start with liquidity, its ability to meet cash obligations when due. Liquidity ratios compare near-term resources with near-term obligations. Leverage describes reliance on borrowed money; coverage compares earnings with a financing cost. Each answers a different question about financial flexibility.
The balance sheet supplies the balances for liquidity ratios, reporting assets and liabilities on a particular date. The income statement reports revenue, expenses, and earnings over a period. The cash flow statement explains cash movements during that period. Combining these statements connects available resources with the company's ability to replenish them. Securities and Exchange Commission financial statement guide
Current assets generally include cash and assets expected to be collected, sold, or consumed within a year or operating cycle. Current liabilities generally include obligations due within that horizon.
Common mistakes
- Mixing quick-ratio forms. In Example 1, the narrow form gives $80 ÷ $75 = 1.07 times, while the simpler current-assets-less-inventory form gives ($150 − $60) ÷ $75 = 1.20 times. Use the form the stem names.
- Mixing turnover periods. Quarterly receivables turnover of 2 times over 90 days gives 90 ÷ 2 = 45 days. Using 365 produces the trap answer of 182.5 days.
- Adding supplier days. For the cash collection cycle example, 36.5 + 50 + 36.5 = 123 days is wrong. Subtract supplier days to obtain 50 days.
Bottom line
- Current ratio divides current assets by current liabilities; working capital subtracts current liabilities from current assets.
- The narrow quick ratio adds cash and equivalents, marketable short-term investments and net receivables; the simpler form subtracts only inventory from current assets; use the stated form.
- Operating cash flow less capital expenditures is a common free cash flow measure; equity-based free cash flow yield uses equity market capitalization.
- Net debt subtracts eligible cash from defined interest-bearing debt.
Exam shortcut
Identify the requested denominator before calculating: current liabilities, equity, debt plus equity, EBITDA, or interest expense. Cross out figures belonging to another ratio. For an acid-test ratio, confirm which form the stem uses. Mark restricted cash before calculating net debt. For turnover questions, pair receivables with credit sales, inventory with COGS, and payables with credit purchases. Convert each turnover into days before combining the cycle.
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Learning objectives
- A3
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