Activity, Liquidity, Solvency and Profitability Ratios

Financial ratios are used to express one financial quantity regarding another. Financial ratios can assist with company and security valuations, stock selections, and forecasting.

A variety of categories may be used to classify financial ratios. Although the names of these categories and the ratios included in each can vary significantly, common categories used include activity, liquidity, solvency, profitability, and valuation ratios. Each category measures a different aspect of a company’s business. However, all categories are essential in evaluating a company’s ability to generate cash flows from its business operations.

Financial ratios require contextual interpretation. Typically, they are compared with:

• Prior Period Results: Trend analysis can highlight whether a company’s performance and financial position are improving or deteriorating over time.
• Expectations: These are forecasts or estimates for key metrics like sales growth, profit margins, and leverage ratios set by the analyst or external analysts before the actual results are published. Variances from these expectations should be analyzed to adjust forecasts for future periods.
• Industry Peers and Competitors (Cross-Sectional Analysis): Comparing a company with others in its industry involves relating its financial ratios to industry norms or a subset of companies in the same industry. When using industry norms, several considerations should be kept in mind:
  • Companies may operate in multiple lines of business, which can distort aggregate financial ratios. It’s better to examine industry-specific ratios for each line of business.
  • Different business models and corporate strategies can impact certain financial ratios.
  • Some ratios are specific to certain industries and may not be relevant across all industries.
  • Variations in accounting methods used by different companies can distort financial ratios.
• Company Goals and Strategy: Actual financial ratios can be compared with the company’s goals to assess whether these objectives are being met and if the results align with the company’s strategy.
• Economic Conditions: For cyclical companies, financial ratios generally improve when the economy is strong and declines during recessions. Therefore, financial ratios should be evaluated in the context of the current phase of the business cycle.

Activity Ratios

Activity ratios are also known as asset utilization ratios or operating efficiency ratios. They measure how efficiently a company performs daily tasks, such as managing various assets. These ratios generally combine income statement information in the numerator and balance sheet information in the denominator.

The list below describes the most commonly used activity ratios.

Inventory Turnover and Days of Inventory on Hand (DOH)

Inventory turnover is calculated as

$$ \text{Inventory turnover}=\frac {\text{Cost of goods sold}}{\text{Average inventory}} $$

Inventory turnover reflects the amount of resources invested in inventory, also called the carrying costs, and can serve as an indicator of inventory management effectiveness.

On the other hand, DOH is calculated as:

$$ DOH=\frac {\text{Number of days in period}}{\text{Inventory turnover}} $$

The ratio can also be used to measure the effectiveness of inventory management.

Receivables Turnover and Days of Sales Outstanding (DSO)

Receivables turnover is given by:

$$ \text{Receivables turnover}=\frac {\text{Revenue}}{\text{Average receivables}} $$

The receivable turnover ratio measures the efficiency of a company’s credit and collection processes. A relatively high receivables turnover ratio may indicate a company has highly efficient credit and collections. Similarly, it could imply that a company’s credit or collection policies are too stringent.

On the other hand, the day of sales outstanding is calculated as:

$$ DSO=\frac {\text{Number of days in period}}{\text{Receivables turnover}} $$

DSO measures the time that elapses between a sale and cash collection. It reflects how fast a company collects cash from customers to whom it extends credit. A low DSO indicates that a company is efficient in its credit and collection processes.

Similar to inventory management, comparing the company’s sales growth to the industry can help analysts determine if sales are being lost due to strict credit policies. Additionally, comparing the company’s estimates of uncollectible accounts receivable and actual credit losses with past experiences and peer companies can help assess whether low turnover is due to credit management issues.

Payables Turnover and Number of Days of Payables

Payables turnover is calculated as:

$$ \text{Payables turnover}=\frac {\text{Purchases}}{\text{Average trade payables}} $$

Payables turnover measures the number of times a company theoretically pays off all its creditors per year.

On other hand, the number of days of payables is computed as:

$$ \text{Number of days of payables}=\frac {\text{Number of days in period}}{\text{Payables turnover}} $$

The number of payable days reflects the average number of days a company takes to pay its suppliers.

A high payables turnover ratio (low days payable) compared to the industry might suggest that the company is not fully utilizing available credit facilities or is taking advantage of early payment discounts. Conversely, a low turnover ratio (high days payable) could signal difficulties in making timely payments or taking advantage of lenient supplier terms.

In such cases, examining other ratios simultaneously is beneficial. If liquidity ratios show the company has enough cash and short-term assets to meet obligations while having a high days payable ratio, the analyst might lean towards lenient supplier credit and collection policies as the reason.

Working Capital Turnover

Working capital turnover is calculated as

$$ \text{Working capital turnover}=\frac {\text{Revenue}}{\text{Average working capital}} $$

Working capital turnover indicates how efficiently a company generates revenue with its working capital. According to the formula for working capital turnover, a working capital turnover ratio of 5.0, for example, means that the company produces USD 5 of revenue for every USD 1 of working capital. As such, a high working capital turnover ratio indicates greater efficiency.

Note that working capital can be close to zero or even negative for some companies, making the working capital turnover ratio difficult to interpret accurately.

Fixed Asset Turnover

Fixed asset turnover is calculated as:

$$ \text{Fixed asset turnover}=\frac {\text{Revenue}}{\text{Average net fixed assets}} $$

Fixed asset turnover measures how efficiently a company generates revenues from its investments in fixed assets. A higher fixed asset turnover ratio indicates a more efficient use of fixed assets in generating revenue.

Total Asset Turnover

Total asset turnover is defined as:

$$ \text{Total asset turnover}=\frac {\text{Revenue}}{\text{Average total assets}}$$

Total asset turnover measures a company’s overall ability to generate revenues with a given level of assets. That is, a total asset turnover ratio of 1.50 would indicate that the company generates USD 1.20 in revenue for every USD 1 of average assets. As such, a low asset turnover ratio can indicate inefficiency or the company’s relative capital intensity.

Example: Interpreting DSO and DOH

ABC Corporation is a fictional manufacturing firm. To analyze management’s operational efficiency, an analyst gathers the following activity ratios from a reliable data source.

$$\begin{array}{l|c|c|c|c}
\textbf{Ratio} & \textbf{2019} & \textbf{2018} & \textbf{2017} & \textbf{2016} \\ \hline
\text{Days of Inventory Held (DOH)} & 34.21 & 39.30 & 41.80 & 47.10 \\ \hline
\text{Days Sales Outstanding (DSO)} & 44.00 & 55.30 & 50.20 & 75.50 \\ \hline
\text{Total Asset Turnover} & 0.40 & 0.32 & 0.25 & 0.21 \\
\end{array}$$

Which of the following statements best explains the decrease in DOH from 39.30 in 2018 to 34.21 in 2019 for ABC Corporation?

A. The company increased its sales significantly in 2019.

B. The company extended its credit terms to customers.

C. The company reduced its inventory levels due to an inventory correction.

Solution

The correct answer is C.

The decrease in DOH is primarily due to an inventory correction, where the company recorded an allowance for the decline in market value and obsolescence of inventory. DOH (Days of Inventory Held) is calculated as:

$$ \text{DOH}=\frac {\text{Number of days in period}}{\text{Inventory turnover}} $$

where,

$$ \text{Inventory turnover}=\frac {\text{Cost of goods sold}}{\text{Average inventory}} $$

When the company reduces the value of its inventory due to an allowance for obsolescence, the numerator (Average Inventory) decreases, leading to a lower DOH.

A is incorrect. While increased sales can impact various metrics, the primary reason for the decrease in DOH was the inventory correction and allowance, which directly affected the numerator in the DOH formula.

B is incorrect. Extending credit terms would primarily affect DSO (Days Sales Outstanding), not DOH. DSO is calculated as:

$$ \text{DSO}=\frac {\text{Number of days in period}}{\text{Receivables turnover}} $$

where

$$ \text{Receivables turnover}=\frac {\text{Revenue}}{\text{Average receivables}} $$

Extending credit terms would increase Accounts Receivable, impacting DSO rather than DOH.

Liquidity Ratios

Liquidity ratios measure a company’s ability to satisfy its short-term obligations. These ratios reflect a company’s position at a point in time. They, therefore, usually use ending balance sheet data rather than averages. The list below describes the most commonly used liquidity ratios.

Current Ratio

The current ratio is calculated as follows:

$$ \text{Current ratio}=\frac {\text{Current assets}}{\text{Current liabilities}}$$

A higher current ratio signifies greater liquidity, indicating a stronger ability to meet short-term obligations. Conversely, a lower current ratio suggests less liquidity, implying a higher dependency on operating cash flow and external financing to fulfill short-term obligations. The current ratio assumes that inventories and accounts receivable are liquid.

Quick Ratio

The quick ratio is calculated as:

$$ \text{Quick ratio}=\frac {\text{Cash}+\text{Short-term marketable investments}+\text{Receivables}}{\text{Current liabilities}} $$

A higher quick ratio indicates a higher level of liquidity or ability to meet short-term obligations. It is a better indicator of liquidity than the current ratio in instances where inventory is illiquid.

The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets, also known as “quick assets,” in relation to current liabilities. Similar to the current ratio, a higher quick ratio indicates greater liquidity.

By being conservative, it implies that quick ratio takes into account that certain current assets, such as prepaid expenses, some taxes, and employee-related prepayments, represent costs paid in advance and cannot usually be converted back into cash. It also considers that inventory might not be easily and quickly converted into cash and that a company might not be able to sell all its inventory at its carrying value, especially if required to do so quickly.

Therefore, in situations where inventories are illiquid, as indicated by low inventory turnover ratios, the quick ratio may provide a better indication of liquidity than the current ratio.

Cash Ratio

Cash ratio is defined as:

$$ \text{Cash ratio}=\frac {\text{Cash}+\text{Short-term marketable investments}}{\text{Current liabilities}} $$

The cash ratio is typically a reliable measure of an entity’s liquidity during a crisis because it includes only highly marketable short-term investments and cash. However, during a general market crisis, the fair value of marketable securities could drop significantly due to market factors, which might render this ratio less reliable.

Defensive Interval Ratio

The defensive interval ratio is computed as follows:

$$ \begin{align*} & \text{Defensive interval ratio}\\ &=\frac {\text{Cash}+\text{Short-term marketable investments}+\text{Receivables}}{\text{Daily cash expenditures}} \end{align*} $$

The defensive interval ratio measures how long a company can pay its daily expenditures using only its existing liquid assets without any additional cash inflow.

Cash Conversion Cycle (or Net Operating Cycle)

The cash conversion cycle is calculated using the following formula:

$$ \text{Cash conversion cycle}=\text{DOH}+\text{DSO}-\text{Number of days of payables} $$

The cash conversion cycle metric measures the time span from when a company invests in working capital until it collects cash.

A shorter cash conversion cycle indicates higher liquidity, meaning the company only needs to finance its inventory and accounts receivable for a brief period. Conversely, a longer cash conversion cycle signals lower liquidity, suggesting that the company must finance its inventory and accounts receivable for an extended period, potentially requiring more capital to fund current assets.

Solvency Ratios

Solvency ratios measure a company’s ability to satisfy its long-term obligations. They provide information about the relative debt amount in a company’s capital structure. Moreover, they reveal the adequacy of a company’s earnings and cash flow to cover interest expenses and other fixed charges as they fall due.

There are two types of solvency ratios: debt ratios, which focus on the balance sheet and measure the amount of debt capital relative to equity capital, and coverage ratios, which focus on the income statement and measure the ability of a company to cover its debt payments. Both ratios help assess a company’s solvency and evaluate the quality of its bonds and other debt obligations.

Below is a list of the most used solvency ratios (Debt Ratios).

Debt-to-Assets Ratio

By the name, the debt-to-asset ratio is calculated as:

$$ \text{Debt-to-Asset ratio}=\frac {\text{Total debt}}{\text{Total assets}} $$

Debt-to-Asset ratio measures the percentage of a company’s total assets financed with debt. A higher ratio implies higher financial risk and weaker solvency.

Debt-to-Capital Ratio

Debt-to-capital ratio is computed as:

$$ \text{Debt-to capital ratio}=\frac {\text{Total debt}}{\text{Total debt}+\text{Total shareholders’ equity}}$$

Debt-to-capital ratio measures the percentage of a company’s capital (debt + equity) represented by debt. A higher ratio implies higher financial risk and weaker solvency.

Debt-to-Equity Ratio

The debt-to-equity ratio is calculated as:

$$ \text{Debt-to-equity ratio}=\frac {\text{Total debt}}{\text{Total shareholders’ equity}} $$

The debt-to-equity ratio measures the amount of debt capital relative to equity capital. A higher ratio implies higher financial risk and weaker solvency.

Financial Leverage Ratio

Financial leverage ratio is defined as:

$$ \text{Financial leverage ratio}=\frac {\text{Average total assets}}{\text{Average total equity}} $$

This measures the number of total assets that are supported for each money unit of equity. The higher the ratio, the more leveraged the company uses debt and other liabilities to finance assets.

Debt-to-EBITDA Ratio

The formula for debt-to-EBITDA is given by:

$$ \text{Debt-to-EBITDA}=\frac {\text{Total or net debt}}{\text{EBITDA}} $$

The debt-to-EBITDA ratio calculates the years needed to repay total debt using EBITDA (an approximation of operating cash flow). It’s often used in debt covenants between issuers and investors.

The coverage ratios include:

Interest Coverage Ratio

Calculated as:

$$ \text{Interest coverage}=\frac {\text{EBIT}}{\text{Interest payments}} $$

Interest coverage measures the number of times a company’s EBIT could cover its interest payments. A higher ratio indicates more robust solvency.

Fixed-charge Coverage Ratio

Fixed-charge coverage is calculated as:

$$ \text{Fixed-charge coverage ratio}=\frac {\text{EBIT}+\text{Lease payments}}{\text{Interest payments}+\text{Lease payments}} $$

The fixed-charge coverage ratio measures the number of times a company’s earnings (before interest, taxes, and lease payments) can cover its interest and lease payments. A higher ratio indicates more robust solvency.

Example: Calculating Financial Leverage

HydroElec, a Canadian public utility, is being assessed for solvency by a credit analyst based on financial statements for the year ending 31 December 2023. The following data has been extracted from the company’s 2023 annual report:

$$
\begin{array}{l|c|c|c}
\textbf{Item} & \textbf{2023} & \textbf{2021} & \textbf{2020} \\ \hline
\text{Total Assets} & 850,000 & 790,000 & 720,000 \\ \hline
\text{Short-Term Debt} & 25,000 & 20,000 & 18,000 \\ \hline
\text{Long-Term Debt} & 400,000 & 350,000 & 300,000 \\ \hline
\text{Total Liabilities} & 600,000 & 550,000 & 500,000 \\ \hline
\text{Total Equity} & 250,000 & 240,000 & 220,000 \\
\end{array}$$

Which of the following best describes the trend in HydroElec’s financial leverage from 2021 to 2023?

A. The financial leverage increased, indicating higher risk.

B. The financial leverage remained the same.

C. The financial leverage decreased, indicating lower risk.

Solution:

The correct answer is A.

We start by calculating financial leverage for each year. To determine HydroElec’s financial leverage, we calculate the average total assets and average total equity for the years 2021 and 2023. The average total assets for 2023 are:

$$ \text{Average Total Assets 2023} = \frac{850,000 + 790,000}{2} = 820,000 $$

The average total equity for 2023 is:

$$ \text{Average Total Equity 2023} = \frac{250,000 + 240,000}{2} = 245,000 $$

The financial leverage ratio for 2023 is then:

$$ \text{Financial Leverage 2023} = \frac{820,000}{245,000} = 3.35 $$

For 2021, the average total assets were:

$$\text{Average Total Assets 2021} = \frac{790,000 + 720,000}{2} = 755,000 $$

The average total equity for 2021 was:

$$ \text{Average Total Equity 2021} = \frac{240,000 + 220,000}{2} = 230,000 $$

The financial leverage ratio for 2021 was:

$$ \text{Financial Leverage 2021} = \frac{755,000}{230,000} = 3.28 $$

The trend indicates an increase in financial leverage from 3.28 in 2021 to 3.35 in 2023, suggesting a rise in financial risk.

B is incorrect. The financial leverage ratio actually increased, not remained the same.

C is incorrect. The financial leverage ratio increased, indicating a higher level of risk.

Profitability Ratios

Profitability ratios measure a company’s ability to generate profits from its resources (assets). There are two types of profitability ratios: (i) return-on-sales profitability ratios, which express various sub-totals on the income statement as a percentage of revenue, and (ii) return-on-investment profitability ratios, which measure income relative to the assets, equity, or total capital employed by a company.

The list below describes the most used solvency ratios:

Gross Profit Margin

Definition:

$$ \text{Gross profit margin}=\frac {\text{Gross profit}}{\text{Revenue}} $$

Gross profit margin indicates the percentage of revenue available to cover operating and other expenses and generate profit. A higher gross profit margin indicates a combination of higher product pricing and lower product costs.

Operating Profit Margin

Definition:

$$ \text{Operating profit margin}=\frac {\text{Operating income}}{\text{Revenue}} $$

An operating profit margin that increases faster than the gross profit margin can indicate improvements in controlling operating costs, such as administrative overheads. On the other hand,

Pretax Margin

Definition:

$$ \text{Pretax margin}=\frac {EBT}{\text{Revenue}} $$

Pretax margin reflects the effect on the profitability of leverage and other non-operating income and expenses.

Net Profit Margin

$$ \text{Net profit margin}=\frac {\text{Net income}}{\text{Revenue}} $$

Net profit margin measures how much each dollar collected as revenue translates into profit.

Return on Assets (ROA)

Return on Assets (ROA) evaluates the earnings a company generates from its assets. A higher ROA indicates that the company is efficiently generating more income with a given asset level. This ratio is commonly calculated as follows:

$$ \text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}} $$

A potential issue with this calculation is that net income represents returns to equity holders, while assets are funded by both equity and debt. Since interest expense is subtracted in the numerator, some analysts prefer to add back interest expense, adjusted for taxes, as follows:

$$ \text{Adjusted ROA} = \frac{\text{Net Income} + \text{Interest Expense} \times (1 – \text{Tax Rate})}{\text{Average Total Assets}} $$

Alternatively, some analysts use a pre-interest and pre-tax basis to calculate operating ROA, given by:

$$\text{Operating ROA} = \frac{\text{Operating Income (EBIT)}}{\text{Average Total Assets}} $$

Operating ROA  measures returns before deducting interest on debt, reflecting the return on all invested assets, regardless of how they are financed.

Return on Invested Capital

Definition:

$$ \begin{align*} & \text{Return on Invested Capital} \\ &=\frac {\text{EBIT}\times(1-\text{Effective tax rate)}}{\text{Average total short and long-term debt and equity}} \end{align*} $$

Return on invested capital (ROIC) assesses a company’s after-tax profitability on all its employed capital, including short-term debt, long-term debt, and equity. It’s calculated before deducting interest on debt capital, similar to operating ROA.

Return on Equity (ROE)

Definition:

$$ \text{Return on Equity}=\frac {\text{Net income}}{\text{Average total equity}} $$

ROE measures the return a company earns on its equity capital, including minority equity, preferred equity, and common equity.

Return on Common Equity

Definition:

$$ \text{Return on Common Equity}=\frac {\text{Net income}-\text{Preferred dividends}}{\text{Average common equity}} $$

Return on common equity measures the return earned by a company only on its common equity.

Example: Evaluation of a Company Using Ratio Analysis

The following information on a company is provided for the periods ended December 31, 2015, and December 31, 2016.

$$ \begin{array}{l|c|c}
\text{Ratios} & {\text{December } 31, 2016} & {\text{December } 31, 2015} \\ \hline
\text{Return on equity} & 5.75\% & 4.12\% \\ \hline
\text{Return on assets} & 3.17\% & 2.98\% \\ \hline
\text{Current ratio} & 2.13 & 1.53 \\ \hline
\text{Inventory turnover} & 5.8 & 1.7 \\ \hline
\text{Net profit margin} & 3.23\% & 1.56\% \\ \hline
\text{Debt-to-assets} & 56.23\% & 65.00\%
\end{array} $$

Evaluate the performance of the company using ratio analysis

Solution

The table demonstrates that overall, the company’s performance improved from 2015 to 2016. This is highlighted by:

• An increase in profitability is indicated by increases in the values of the ROE, ROA, and net profit margin ratios;
• An increase in liquidity as indicated by the increase in the current ratio;
• The increase in the inventory turnover ratio evidences an increase in asset utilization.
• Stronger solvency as evidenced by the decrease in the debt-to-assets ratio.

Question 1

You have been provided with the following information on Company ABC for the year 2020:

Revenue: $5,276,987;

Gross profit: $3,534,099; and

Net income: $2,956,123.

Company ABC’s net profit margin is closest to:

1. 56.02%.
2. 66.97%
3. 83.64%

Solution

The correct answer is A.

$$ \text{Net profit margin}=\frac {\text{Net income}}{\text{Revenue}}=\frac {\$2,956,123}{\$5,276,987}=56.02\% $$

Question 2

Which of the following categories of ratios could be used to evaluate a company’s ability to repay a bank loan?

1. Liquidity ratios.
2. Solvency ratios.
3. Profitability ratios.

Solution

The correct answer is B.

Solvency ratios measure a company’s ability to meet long-term obligations such as bank loans and bond obligations.

A is incorrect. Liquidity ratios measure a company’s ability to satisfy its short-term obligations.

C is incorrect. Profitability ratios measure a company’s ability to generate profits from its resources (assets).