A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization.
Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
The cash ratio is the ratio of a company’s total cash and cash equivalents to its current liabilities. The metric calculates a company’s ability to repay its short-term debt; this information is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party. The cash ratio is generally a more conservative look at a company’s ability to cover its liabilities than many other liquidity ratios because other assets, including accounts receivable, are left out of the equation.
The cash ratio is most commonly used as a measure of company’s liquidity. The metric calculates a company’s ability to pay current liabilities using only cash and cash equivalents on hand. If the company is forced to pay all current liabilities immediately, this metric shows the company’s ability to do so without having to sell or liquidate other assets.
Items Omitted From the Cash Ratio
Accounts receivable, inventory, prepaid assets and certain investments are not included in the cash ratio. These items may require time and effort to find a buyer in the market. In addition, the amount of money received from the sale of any of these items may be indeterminable. The cash ratio restricts the asset portion of the equation to only the most liquid of assets.
The efficiency ratio is typically used to analyze how well a company uses its assets and liabilities internally. An efficiency ratio can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and machinery. This ratio can also be used to track and analyze the performance of commercial and investment banks.
Analysts use efficiency ratios, also known as activity ratios, to measure the performance of a company’s short-term or current performance. All of these ratios use numbers in a company’s current assets or current liabilities, quantifying the operations of the business.
An efficiency ratio measures a company’s ability to use its assets to generate income. For example, an efficiency ratio often looks at aspects of the company, such as the time it takes to collect cash from customers or the amount of time it takes to convert inventory to cash. This makes efficiency ratios important, because an improvement in the efficiency ratios usually translates to improved profitability.
These ratios can be compared to peers in the same industry and can identify businesses that are better managed relative to the others. Some common efficiency ratios are accounts receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales and stock turnover ratio.
Efficiency Ratios for Banks
The efficiency ratio also applies to banks. For example, a bank efficiency ratio measures a bank’s overhead as a percentage of its revenue. Like the efficiency ratios above, this allows analysts to assess the performance of commercial and investment banks.
For a bank, an efficiency ratio is an easy way to measure the ability to turn assets into revenue. Since a bank’s operating expenses are in the numerator and its revenue is in the denominator, a lower efficiency ratio means that a bank is operating better. I’s believed that a ratio of 50% is the maximum optimal efficiency ratio. If the efficiency ratio increases, it means a bank’s expenses are increasing or its revenues are decreasing.
An Example of Efficiency Ratio
For example, Bankwell Financial Group Inc. reported second quarter 2016 earnings on July 27, 2016. The report stated that the financial group had an efficiency ratio of 57.1%, which was lower than the 63.2% ratio it reported for the same quarter in 2015. This means the company’s operations became more efficient; it increased its assets by $80 million for the quarter.
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.
Market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices. Cash is considered the most liquid asset, while real estate, fine art and collectibles are all relatively illiquid.
Accounting liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them.
Cash is considered the standard for liquidity, because it can most quickly and easily be converted into other assets. If a person wants a $1,000 refrigerator, cash is the asset that can most easily be used to obtain it. If that person has no cash but a rare book collection that has been appraised at $1,000, he is unlikely to find someone willing to trade them the refrigerator for their collection. Instead, he will have to sell the collection and use the cash to purchase the refrigerator. That may be fine if the person can wait months or years to make the purchase, but it could present a problem if the person only had a few days. He may have to sell the books at a discount, instead of waiting for a buyer who was willing to pay the full value. Rare books are an example of an illiquid asset.
Overall Liquidity Ratio
The overall liquidity ratio is a measurement of a company’s capacity to pay for its liabilities with its assets. The overall liquidity ratio is calculated by dividing total assets by the difference between total liabilities and conditional reserves. This ratio is used in insurance company analysis, as well as in the analysis of financial institutions.
Regulators use financial metrics, like the overall liquidity ratio, to determine whether an insurer, bank, or other financial company is healthy enough to cover its liabilities. Other similar metrics include the quick liquidity and current liquidity ratios. Quick liquidity compares liabilities to assets that are readily available for use, including cash, short-term investments, government bonds, and unaffiliated investments.
Financial and insurance companies use the cash that their activities generate to obtain a return. A bank, for example, may primarily use deposits to provide mortgages and other loans. The balance of deposits that it has left over may be kept as cash, or may be invested in liquid assets. Insurance companies are liable for the benefits that they guarantee by underwriting policies. Depending on the duration of the policy, the liability can last anywhere from a few months to a few years. Liabilities that end after one year are considered current liabilities.
The amount of money that the financial institution or insurer has to keep readily available to cover assets is determined by regulators. Regulators examine liquidity ratios to determine whether the company is complying with its legal requirements. A low overall liquidity ratio could indicate that the financial or insurance company is in financial trouble, whether from poor operational management, risk management, or investment management. A high overall liquidity ratio isn’t necessarily good either, especially if current assets represent a high percentage of total assets. A large proportion of current assets means that the company may not be earning a high enough return on assets as it may be focusing too much on liquidity.
Capitalization Ratios (also known as leverage ratios).
Capitalization ratios are Indicators that measure the proportion of debt in a company’s capital structure. Capitalization ratios include the debt-equity ratio, long-term debt to capitalization ratio and total debt to capitalization ratio. The formula for each of these ratios is shown below.
– Debt-Equity ratio = Total Debt / Shareholders’ Equity
– Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt + Shareholders’ Equity)
– Total Debt to Capitalization = Total Debt / (Total Debt + Shareholders’ Equity)
While a high capitalization ratio can increase the return on equity because of the tax shield of debt, a higher proportion of debt increases the risk of bankruptcy for a company.
For example, consider a company with short-term debt of $5 million, long-term debt of $25 million and shareholders’ equity of $50 million. The company’s capitalization ratios would be computed as follows –
– Debt-Equity ratio = ($5 million + 25 million) / 50 million = 0.60 or 60%
– Long-term Debt to Capitalization = $25 million / ($25 million + $50 million) = 0.33 or 33%
– Total Debt to Capitalization = ($5 million + $25 million) / ($5 million + $25 million + $50 million) = 0.375 or 37.5%
The acceptable level of capitalization ratios for a company depends on the industry in which it operates. Companies in sectors such as utilities, pipelines and telecommunications – which are capital intensive and have predictable cash flows – will typically have capitalization ratios on the higher side. Conversely, companies with relatively few assets that can be pledged as collateral – in sectors like technology and retail – will have lower levels of debt and therefore lower capitalization ratios.
The acceptable level of debt for a company is dependent on its whether its cash flows are adequate to service such debt. The interest coverage ratio, another popular leverage ratio, measures the ratio of a company’s earnings before interest and taxes (EBIT) to its interest expense. A ratio of 2, for instance, indicates the company generates $2 for every dollar in interest expense.
As with all ratios, a company’s capitalization ratios should be tracked over time to identify if they are stable. They should also be compared with similar ratios of peer companies, to ascertain the company’s leverage position relative to its peers.
Activity ratios measure a firm’s ability to convert different accounts within its balance sheets into cash or sales. Activity ratios measure the relative efficiency of a firm based on its use of its assets, leverage or other such balance sheet items and are important in determining whether a company’s management is doing a good enough job of generating revenues and cash from its resources.
Companies typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues, so analysts perform fundamental analysis by using common ratios such as the total assets turnover ratio and inventory turnover.
Activity ratios measure the amount of resources invested in a company’s collection and inventory management. Because businesses typically operate using materials, inventory and debtors, activity ratios determine how well an organization manages these areas. Activity ratios are one major category in which a ratio may be classified; other ratios may be classified as measurements of liquidity, profitability or leverage.
Activity ratios gauge an organization’s operational efficiency and profitability. Activity ratios are most useful when compared to competitor or industry to establish whether an entity’s processes are favorable or unfavorable. Activity ratios can form a basis of comparison across multiple reporting periods to determine changes over time.
The following activity ratios may be analyzed as some of an organization’s key performance indicators.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio determines an entity’s ability to collect money from its customers. Total credit sales are divided by the average accounts receivable balance for a specific period. This activity ratio calculates management’s ability to receive cash. A low ratio suggests a deficiency in the collection process.
Merchandise Inventory Turnover Ratio
The merchandise inventory turnover ratio measures how often the inventory balance is sold during an accounting period. The cost of goods sold is divided by the average inventory for a specific period. Higher calculations indicate inventory is quickly converted into sales and cash. A useful way to use this activity ratio is to compare it to previous periods.
Total Assets Turnover Ratio
The total assets turnover ratio take a look at how efficiently an entity uses its assets to make a sale. Total sales are divided by total assets to see how proficient a business is at using its assets. Smaller ratios may indicate that the company is holding higher levels of inventory instead of selling.
Long Term Debt To Total Assets Ratio
The long term debt to total assets ratio is a measurement representing the percentage of a corporation’s assets financed with loans or other financial obligations lasting more than one year. The ratio provides a general measure of the long-term financial position of a company, including its ability to meet financial requirements for outstanding loans.
A year-over-year decrease in long term debt to total assets ratio may suggest a company is progressively becoming less dependent on debt to grow its business. The calculation for the long-term debt to total assets ratio is: long-term debt / total assets = long-term debt to total asset ratio.
Example of Long-Term Debt to Asset Ratio
For example, if a company has $100,000 in total assets with $40,000 in long-term debt, its long-term debt to total asset ratio is $40,000/$100,000 = 0.4 or 40%. This ratio indicates that the company has 40 cents of long-term debt for each dollar it has in assets. In order to compare the overall leverage position of the company, investors look at comparable firms and the historical changes in this ratio.
What Does the Long-Term Debt to Asset Ratio Symbolize?
If a business has a high long-term debt to asset ratio, it suggests the business has a relatively high degree of risk, and eventually, it may not be able to repay its debts. This makes lenders more skeptical about loaning the business money and investors more leery about buying shares. In contrast, if a business has a low long-term debt to asset ratio, it can signify the relative strength of the business. However, the assertions an analyst can make based on this ratio vary based on the company’s industry as well as other factors, and for this reason, analysts tend to compare these numbers between companies from the same industry.
Difference Between Long-Term Debt to Asset and Total Debt to Asset Ratios
While long-term debt to asset ratio only takes into account long-term debts, the total debt to total asset ratio includes all debts. This ratio takes into account both long-term debts, such as mortgages and securities, and current debts such as rent, utilities and short-term loans. Both ratios, however, take into account all of a business’s assets including tangible assets such as equipment and inventory and intangible assets such as accounts receivables. Because the total debt to asset ratio includes more of a company’s liabilities, this ratio is almost always higher than a company’s long-term debt to asset ratio.
Quick Liquidity Ratio
The total amount of a company’s quick assets divided by the sum of its net liabilities and its reinsurance liabilities. Quick assets are liquid assets such as cash, short-term investments, equities, and corporate bonds nearing maturity. The quick liquidity ratio shows the amount of liquid assets an insurance company can tap into on short notice.
The quick liquidity ratio is an important measure of an insurance company’s ability to cover its liabilities with relatively liquid assets. A company with a low quick liquidity ratio that finds itself with a sudden increase in liabilities may have to sell off long-term assets or borrow money in order to cover its liabilities. For example, an insurance company may find itself with a sudden increase in liabilities if a hurricane causes significant damage to its policy holders.
Quick liquidity ratios are expressed as a percentage. The range of percentages considered good depend on the type of policies that an insurance company is providing. Property insurers are likely to have quick liquidity ratios greater than 30%, while liability insurers may have ratios above 20%. A company that offers a mixture of different types of insurance policies is best compared to companies that offer a similar mixture, as opposed to comparing that company to insurers who only offer a specific and smaller range of products.
When evaluating a potential investment in an insurance company an investor should evaluate the types of policies that the company offers, as well as how the company intends on covering its liabilities in the case of an emergency. In addition to evaluating the quick liquidity ratio, investors should look at a company’s current liquidity ratio which shows how well a company can cover liabilities with invested assets, and overall liquidity ratio which shows how a company can cover liabilities with total assets. Investors can also review operating cash flows and net cash flows to determine how the company can meet its short-term liquidity needs from cash.
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