Measures of Liquidity and Solvency Financial Metrics 2: Measures of Liquidity and Solvency This module covers the definitions of common financial measures used in business for measuring financial risk including Working Capital, Current Ratio, Quick Ratio, Cash Ratio, Operating Cash Flow Ratio, Solvency Ratio, Debt to Equity, Long-Term Debt to Capitalization Ratio, Total Debt to Total Assets, Interest Coverage Ratio, and Cash Flow to Debt Ratio. Author: Stu James © 2018 Stu James and Management by the Numbers, Inc.

Measures of Liquidity and Solvency Liquidity and Solvency Metrics are primarily based on values found on the balance sheet and measure the ability of the firm to pay what it owes to vendors and creditors – its financial obligations. Liquidity Measures of risk focus on a firm’s short term ability to honor its obligations and include: Working Capital, Current Ratio, Quick Ratio, Cash Ratio, and Operating Cash Flow Ratio. Solvency Measures of risk focus on a firm’s long term ability to honor its obligations and include: Solvency Ratio, Debt to Equity, Long-Term Debt to Capitalization, Total Debt to Total Assets, and Interest Coverage Ratio. We’ll use a very simple business, shown on the next slide, to illustrate these various measures. MBTN | Management by the Numbers

Example Business MBTN | Management by the Numbers Sherry owns a small online gardening supply business and has the following assets and liabilities from her balance sheet as of December 31, 2017. We’ll also consider her cash flow and income statements in a few examples. Now, let’s learn about some measures of liquidity and solvency that will provide insight into the health of Sherry’s business. Sherry’s Garden $000s Retained Earnings 300 Capital Surplus 100 Total Shareholders Equity 400 Sherry’s Garden - Assets $000s Cash and Cash Equivalents 15 Marketable Securities 5 Receivables 60 Inventory 220 Total Current Assets 300 Long Term Investments 20 Plant, Property and Equipment 850 Intangible Assets 10 Other Assets Total Assets 1200 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Long Term Debt 550 Other Liabilities 50 Total Liabilities 800 MBTN | Management by the Numbers

Working Capital Definition Question 1 Working Capital measures the operating liquidity of a business or a company’s ability to pay for its ongoing operations - often called Net Working Capital. Working Capital ($) = Current Assets ($) – Current Liabilities ($) Sherry’s Garden - Assets $000s Cash and Cash Equivalents 15 Marketable Securities 5 Receivables 60 Inventory 220 Total Current Assets 300 Question 1 What is the Working Capital for Sherry’s Garden as of Dec 31, 2017? Answer: Working Capital = $300,000 - $200,000 = $100,000 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 MBTN | Management by the Numbers

Current Ratio Definition Question 2 Current Ratio also measures the operating liquidity of a business using the same values and is sometimes know as the Working Capital Ratio. Current Ratio = Current Assets ($) / Current Liabilities ($) Sherry’s Garden - Assets $000s Cash and Cash Equivalents 15 Marketable Securities 5 Receivables 60 Inventory 220 Total Current Assets 300 Question 2 What is the Current Ratio for Sherry’s Garden as of Dec 31, 2017? Answer: Current Ratio = $300,000 / $200,000 = 1.5 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 MBTN | Management by the Numbers

Quick Ratio Definition Question 3 Quick Ratio also measures the operating liquidity of a business but excludes inventory. Sometimes known as the Acid Test Ratio. Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities Question 3 What is the Quick Ratio for Sherry’s Garden as of Dec 31, 2017? Sherry’s Garden - Assets $000s Cash and Cash Equivalents 15 Marketable Securities 5 Receivables 60 Inventory 220 Total Current Assets 300 Answer: Quick Ratio (values in 000s) = ($15 + $5 + $60) / $200 = .40 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Insight Removing inventory is a more conservative measure of liquidity as we don’t know how quickly the inventory will be sold. MBTN | Management by the Numbers

Cash Ratio Definition Question 4 Cash Ratio is the most conservative measure of a company’s liquidity as it calculates if cash and securities cover the company’s short term liabilities. Cash Ratio = (Cash + Marketable Securities) / Current Liabilities Sherry’s Garden - Assets $000s Cash and Cash Equivalents 15 Marketable Securities 5 Receivables 60 Inventory 220 Total Current Assets 300 Question 4 What is the Cash Ratio for Sherry’s Garden as of Dec 31, 2017? Answer: Cash Ratio = ($15,000 + $5,000) / $200,000 = .10 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Insight Like inventory, the quality (age) of the receivables is unknown, so this measure removes both inventory and receivables. MBTN | Management by the Numbers

Operating Cash Flow Ratio Definition Operating Cash Flow Ratio measures the number of times a company can pay off current debts with cash generated in a given time period. Operating CF Ratio = Cash Flow from Operations ($) / Current Liabilities ($) Question 5 What is the Operating Cash Flow Ratio for Sherry’s Garden? Sherry’s Garden - Cash Flow $000s Net Cash Flow-Operating 300 Net Cash Flow-Investing -100 Net Cash Flow Financing 60 Total Cash Flow 260 Answer: Operating Cash Flow Ratio = $300,000 / $200,000 = 1.5 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Note: Sometimes this ratio is calculated using the average current liabilities during the same period as cash flow. This is calculated by adding the current liabilities at the beginning of the period and the end of period and dividing by 2. MBTN | Management by the Numbers

Solvency Ratio Definition Question 6 Solvency Ratio measures the ability of a firm to meet its long-term obligations. Solvency Ratio = (Net Income ($) + Depreciation ($)) / Total Liabilities ($) Question 6 What is the Solvency Ratio for Sherry’s Garden? Sherry’s Garden $000s Net Income / After-Tax Profit 70 Depreciation 30 Income + Depreciation 100 Answer: Solvency Ratio = $100,000 / $800,000 = .125 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Long Term Debt 550 Other Liabilities 50 Total Liabilities 800 Insight As we move from liquidity to solvency ratios, we now focus on total liabilities and debt which include long-term obligations of the firm. MBTN | Management by the Numbers

Debt to Equity Definition Question 7 Debt to Equity (D/E) measures the relative proportion of debt and shareholders’ equity used to finance a business. It is the most common measure of leverage. Debt to Equity = Total Liabilities ($) / Shareholders’ Equity ($) Question 7 What is the Debt to Equity for Sherry’s Garden? Sherry’s Garden $000s Retained Earnings 300 Capital Surplus 100 Total Shareholders Equity 400 Answer: Debt to Equity = $800,000 / $400,000 = 2.0 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Long Term Debt 550 Other Liabilities 50 Total Liabilities 800 Insight There are a few variations of Debt to Equity worth mentioning (see next slide). What is important is to compare apples to apples. MBTN | Management by the Numbers

Debt to Equity Variations Formulas for ratios often look simple enough until we get into greyer areas of definitions. Let’s look at a few of these as they relate to Debt to Equity (D/E). Long-Term Debt to Equity. Similar idea to D/E, but does not include short-term liabilities or debt coming due in the next year. Often this is the definition used as the measure of “leverage”. Preferred Stock, which will be listed under the Shareholders Equity accounts, might be more appropriately considered debt depending on the terms of the stock issued. This is a subjective decision. Other obligations that aren’t captured in total liabilities, such as unearned revenue. MBTN | Management by the Numbers

Long Term Debt to Capitalization Definition Long Term Debt to Capitalization Ratio measures debt as a percent of total capital (debt plus equity). LT Debt to Capitalization = LT Debt / (LT Debt + Shareholders’ Equity) Sherry’s Garden $000s Retained Earnings 300 Capital Surplus 100 Total Shareholders Equity 400 Question 8 What is the LT Debt to Capitalization for Sherry’s Garden? Answer: LT Debt to Capitalization = $550,000 / ($550,000 + $400,000) = .58 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Long Term Debt 550 Other Liabilities 50 Total Liabilities 800 Insight Investors find it valuable to understand how a firm is financed – primarily debt or equity or a balance between the two. MBTN | Management by the Numbers

Long Term Debt to Total Assets Total Debt to Total Assets Long Term Debt to Total Assets Definition Total Debt to Total Assets measures the percentage of assets that are funded through debt rather than equity. Total Debt to Total Assets = Total Liabilities / Total Assets Sherry’s Garden - Assets $000s Short Term Assets 300 Long Term Assets 900 Total Assets 1200 Question 9 What is the Total Debt to Total Assets for Sherry’s Garden? Answer: Total Debt to Total Assets = $800,000 / $1,200,000 = .66 Sherry’s Garden - Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Long Term Debt 550 Other Liabilities 50 Total Liabilities 800 Insight Here again, sometimes debt will be what is labeled debt in the balance sheet while other times it will be total liabilities. Be consistent! MBTN | Management by the Numbers

Interest Coverage Ratio Definition Interest Coverage Ratio measures the ratio of earnings before interest and taxes to interest payments, which indicates ability to pay interest from earnings. Interest Coverage Ratio = EBIT / Interest Expense Question 10 What is the Interest Coverage Ratio for Sherry’s Garden if Net Income before taxes is $100,000, and interest payments are $50,000? Sherry’s Garden – Income Statement $000s Revenues 800 Cost of Goods Sold 600 Other Expenses 50 Operating Income 150 Interest Taxes 30 Net Income 70 Answer: Interest Coverage Ratio = ($100,000 + $50,000*) / $50,000 = 3 *Since earnings are provided before taxes, we just have to add interest payments to Net Income before taxes to calculate EBIT. MBTN | Management by the Numbers

Cash Flow to Debt Ratio Definition Question 5 Cash Flow to Debt Ratio measures the ratio of cash flow to debt to give an indication of a firm’s ability to pay its obligations from cash from operations. Cash Flow to Debt Ratio = Cash Flow from Operations ($) / Debt ($) Sherry’s Garden - Cash Flow $000s Net Cash Flow-Operating 300 Net Cash Flow-Investing -100 Net Cash Flow-Financing 60 Total Cash Flow 360 Question 5 What is the Cash Flow to Debt Ratio for Sherry’s Garden? Sherry’s Garden – Liabilities $000s Accounts Payable 60 Short-Term Debt 120 Other Current Liabilities 20 Total Current Liabilities 200 Long Term Debt 550 Other Liabilities 50 Total Liabilities 800 Answer: Cash Flow to Debt Ratio = $300,000 / ($550,000 + $120,000) = .45 Note: Sometimes the ratio is calculated using total liabilities rather than only liabilities that are labeled as debt on the balance sheet. MBTN | Management by the Numbers

Further Reference Further Reference MBTN Income Statement, Balance Sheet, Cash Flow, and Financial Statements modules that introduce the components of the major financial statements. - And - MBTN Financial Metrics 1 module which describes measures of profitability. MBTN | Management by the Numbers