1. 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.

2. 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

3. 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, 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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