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:

1. Previous periods to identify trends.
2. Expectations or estimates are set by analysts before results.
3. Industry peers and competitors to assess relative performance, considering industry-specific factors.
4. Company objectives and strategies to gauge alignment.
5. Economic conditions, especially for cyclical companies, as ratios can vary with the business cycle phase.

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$$ \text{Inventory turnover}=\frac {\text{Cost of goods sold}}{\text{Average inventory}} $$Interpretation: The ratio can be used to measure the effectiveness of inventory management. A higher inventory turnover ratio implies that inventory is held for a shorter period.
• Days of Inventory on Hand (DOH)$$ DOH=\frac {\text{Number of days in period}}{\text{Inventory turnover}} $$Interpretation: The ratio can also be used to measure the effectiveness of inventory management. A lower DOH implies that inventory is held for a shorter period.
• Receivables Turnover$$ \text{Receivables turnover}=\frac {\text{Revenue}}{\text{Average receivables}} $$Interpretation: This 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.
• Days of Sales Outstanding (DSO)$$ DSO=\frac {\text{Number of days in period}}{\text{Receivables turnover}} $$Interpretation: This 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.
• Payables Turnover$$ \text{Payables turnover}=\frac {\text{Purchases}}{\text{Average trade payables}} $$Interpretation: This measures the number of times a company theoretically pays off all its creditors per year.
• Number of Days of Payables$$ \text{Number of days of payables}=\frac {\text{Number of days in period}}{\text{Payables turnover}} $$Interpretation: This reflects the average number of days a company takes to pay its suppliers.
• Working Capital Turnover$$ \text{Working capital turnover}=\frac {\text{Revenue}}{\text{Average working capital}} $$Interpretation: This indicates how efficiently a company generates revenue with its working capital. A high working capital turnover ratio indicates greater efficiency.
• Fixed Asset Turnover$$ \text{Fixed asset turnover}=\frac {\text{Revenue}}{\text{Average net fixed assets}} $$Interpretation: This 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$$ \text{Total asset turnover}=\frac {\text{Revenue}}{\text{Average total assets}} $$Interpretation: This measures a company’s overall ability to generate revenues with a given level of assets. A low asset turnover ratio can indicate inefficiency or the company’s relative capital intensity.

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$$ \text{Current ratio}=\frac {\text{Current assets}}{\text{Current liabilities}} $$Interpretation: A higher current ratio indicates a higher level of liquidity or ability to meet short-term obligations.
• Quick Ratio$$ \text{Quick ratio}=\frac {\text{Cash}+\text{Short-term marketable investments}+\text{Receivables}}{\text{Current liabilities}} $$Interpretation: 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.
• Cash Ratio$$ \text{Cash ratio}=\frac {\text{Cash}+\text{Short-term marketable investments}}{\text{Current liabilities}} $$Interpretation: The ratio is a reliable measure of liquidity in a crisis.
• Defensive Interval Ratio$$ \begin{align*} & \text{Defensive interval ratio}\\ &=\frac {\text{Cash}+\text{Short-term marketable investments}+\text{Receivables}}{\text{Daily cash expenditures}} \end{align*} $$Interpretation: This measures how long a company can pay its daily expenditures using only its existing liquid assets without any additional cash inflow.
• Other RatiosIn addition to the above ratios, the cash conversion cycle is an additional liquidity measure that can be used.$$ \text{Cash conversion cycle}=\text{DOH}+\text{DSO}-\text{Number of days of payables} $$It measures the time required for a company to go from cash paid (used in operations) to cash received (as a result of operations).

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: (i) debt ratios, which focus on the balance sheet and measure the amount of debt capital relative to equity capital, and (ii) 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-to-Assets Ratio$$ \text{Debt-to-Asset ratio}=\frac {\text{Total debt}}{\text{Total assets}} $$Interpretation: This 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$$ \text{Debt-to capital ratio}=\frac {\text{Total debt}}{\text{Total debt}+\text{Total shareholders’ equity}} $$Interpretation: This 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$$ \text{Debt-to-equity ratio}=\frac {\text{Total debt}}{\text{Total shareholders’ equity}} $$Interpretation: This measures the amount of debt capital relative to equity capital. A higher ratio implies higher financial risk and weaker solvency.
• Financial Leverage Ratio$$ \text{Financial leverage ratio}=\frac {\text{Average total assets}}{\text{Average total equity}} $$Interpretation: 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$$ \text{Debt-to-EBITDA}=\frac {\text{Total or net debt}}{\text{EBITDA}} $$Interpretation: 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.
• Interest Coverage Ratio$$ \text{Interest coverage}=\frac {\text{EBIT}}{\text{Interest payments}} $$Interpretation: This 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$$ \text{Fixed-charge coverage ratio}=\frac {\text{EBIT}+\text{Lease payments}}{\text{Interest payments}+\text{Lease payments}} $$Interpretation: This 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.

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$$ \text{Gross profit margin}=\frac {\text{Gross profit}}{\text{Revenue}} $$Interpretation: This 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$$ \text{Operating profit margin}=\frac {\text{Operating income}}{\text{Revenue}} $$Interpretation: An operating profit margin that increases faster than the gross profit margin can indicate improvements in controlling operating costs, such as administrative overheads.
• Pretax Margin$$ \text{Pretax margin}=\frac {EBT}{\text{Revenue}} $$Interpretation: This reflects the effect on the profitability of leverage and other non-operating income and expenses.
• Net Profit Margin$$ \text{Net profit margin}=\frac {\text{Net income}}{\text{Revenue}} $$Interpretation: This measures how much each dollar collected as revenue translates into profit.
• Operating ROA$$ \text{Operating ROA}=\frac {\text{Operating income}}{\text{Average total assets}} $$Interpretation: This measures the return (before deducting interest on debt capital) a company earns on its assets.
• Return on Assets (ROA)$$ ROA=\frac {\text{Net income}}{\text{Average total assets}} $$Interpretation: This measures the return earned by a company on its assets.
• Return on Invested Capital$$ \begin{align*} & \text{Return on Invested Capital} \\ &=\frac {\text{EBIT}\times(1-\text{Effective tax rate)}}{\text{Average total short and long-term debt and equity}} \end{align*} $$Interpretation: 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)$$ \text{Return on Equity}=\frac {\text{Net income}}{\text{Average total equity}} $$Interpretation: This measures the return a company earns on its equity capital, including minority equity, preferred equity, and common equity.
• Return on Common Equity$$ \text{Return on Common Equity}=\frac {\text{Net income}-\text{Preferred dividends}}{\text{Average common equity}} $$Interpretation: This measures the return earned by a company only on its common equity.

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).