116 Corporate Finance
- Operating ratios
- Profitability ratios
Ratios Measuring a Company’s Liquidity and Indebtedness
Liquidity is a measure of the quality and adequacy of current assets to meet current obligations of the firm as
they mature. Some liquidity ratios are discussed here:
Current Ratio
Computation: Total current assets divided by current liabilities:
Current ratio =
Total current liabilitiesTotal current assetsThis ratio is a rough indication of a firm’s ability to service its current obligations.
Generally, the higher the current ratio, the greater is the cushion available to the firm. A higher ratio
reflects the numerical superiority of current assets over current liabilities. However, it is prudent to look at
the quality and composition of current assets in analyzing the firm’s liquidity. Bankers normally impose a
current ratio of 1.33 on companies.
Quick Ratio
Computation: Cash and equivalents plus trade receivables divided by total current liabilities:
Quick ratio =
Total current liabilitiesCash and equivalent+ Trade receivablesQuick ratio, a variant of the current ratio, measures the degree to which a company’s current liabilities are
covered by the most liquid current assets. Inventory is generally considered not too liquid and hence not
included in the numerator. However, the portion of inventory that can be converted to cash fairly quickly
can be included in the numerator. A ratio of less than 1 implies dependency on other current assets to liquidate
short-term debt. This ratio is also called ‘acid test’ ratio. Highly liquid securities that can be converted to
cash easily and bank deposits are considered cash equivalents.
COVERAGE RATIOS
These ratios measure the ability of the firm to service contractual financial commitments like debt. They
make use of balance sheet and/or income statement numbers to estimate the cushion available (in earnings)
to the firm before it defaults on contractual payments.
Interest Coverage Ratio
Computation: Earnings before interest and taxes divided by interest.
Meaning: This ratio measures the firm’s ability to meet its interest (expense) obligation. A high ratio
indicates a comfortable position as regards debt servicing ability. The figure in the denominator is the actual