A simple dimension reduction procedure for corporate finance composite indicators 209Thecurrent ratio
X 1 =total current assets
total current liabilities, (10)
indicates the company’s ability to meet short-term debt obligations; the higher the
ratio, the more liquid the company is. If the current assets of a company are more
than twice the current liabilities, then that company is generally considered to have
good short-term financial strength. If current liabilities exceed current assets, then the
company may have problems meeting its short-term obligations.
Thequick ratio
X 2 =
total current assets – inventory
total current liabilities, (11)
is a measure of a company’s liquidity and ability to meet its obligations. It expresses
the true working capital relationship of its cash,accounts receivables, prepaids and
notes receivables available to meet the company’s current obligations. The higher the
ratio, the more financially strong the company is: a quick ratio of 2 means that for
every euro of current liabilities there are two euros of easily convertible assets.
Theinterest coverage ratio
X 3 =
earnings before interest and taxes
interest expenses. (12)
The lower the interest coverage ratio, the larger the debt burden is on the company. It
is a measure of a company ability to meet its interest payments on outstanding debt.
A company that sustains earnings well above its interest requirements is in a good
position to weather possible financial storms.
Thecash flow to interest expense ratio
X 4 =
cash flow
interest expenses. (13)
The meaning is clear: a cash flow to interest expense ratio of 2 means that the company
had enough cash flow to cover its interest expenses two times over in a year.
These ratios are important in measuring the ability of a company to meet both
its short-term and long-term obligations. To address company liquidity, one may
sequentially examine each ratio that addresses the problem from a particular (partial)
point of view. For example, the current ratio as well as the quick ratio are regarded as
a test of liquidity for a company, but while the first one expresses the working capital
relationship of current assets available to meet the company’s current obligations, the
second one expresses the true working capital relationship of current assets available
to meet current obligations since it eliminates inventory from current assets. This
is particularly important when a company is carrying heavy inventory as part of
its current assets, which might be obsolete. However, it should be noted that in the
literature the order of their importance is not clear. For more details see for example [9].
A dataset about 338 companies listed on the main European equity markets has
been analysed. We consider listed companies because they have to periodically send