The Safal Niveshak Mastermind Module 3 | Lesson 27

Ratio Analysis – Part II

Module 3 | Lesson 27

In the first lesson on Ratio Analysis, I discussed the importance of the exercise of
analyzing a company’s financial performance using ratios.

I also enlisted the widely accepted ratios that have been found to be useful…

Then, I explained the Activity Ratios in detail. Just to reiterate, activity ratios are
analyzed as indicators of ongoing operational performance – how effectively assets
are used by a company.

These ratios reflect the efficient management of both working capital and longer-
term assets.

As noted, efficiency has a direct impact on liquidity (the ability of a company to meet
its short-term obligations), so some activity ratios are also useful in assessing
liquidity.

In this lesson, I will cover the next two categories – Liquidity and Solvency Ratios.

I. Liquidity Ratios
to meet short-term obligations.

In simple words, liquidity measures how quickly assets are converted into cash.

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So, taking your personal example, the gold that you own is a highly liquid asset
because you can sell it anywhere and get cash. Real estate, on the other hand is less
liquid because, for all the hype about realty prices, you don’t get what you expect
when you go to sell a property. Plus it takes a lot of time to find a buyer.

Coming back to liquidity ratios, they also measure a company’s ability to pay off its
short-term obligations. In day-to-day operations, liquidity management is typically
achieved through efficient use of assets.

Here are a few important liquidity ratios.

These ratios reflect a company’s position at a point in time and, therefore, typically
use data from the ending Balance Sheet rather than averages, like we used while
calculating activity ratios in the previous lesson.

The current and quick ratios reflect two measures of a company’s ability to pay
current liabilities. Each uses a progressively stricter definition of liquid assets.

The cash conversion cycle, a financial metric not in ratio form, measures the length
of time required for a company to go from cash (invested in its operations) to cash
received (as a result of its operations). During this period of time, the company needs
to finance its investment in operations through other sources (i.e., through debt or
equity).

Let’s now understand these liquidity measures, and why they are relevant from an
investor’s point of view.

1. Current Ratio
The most immediate danger faced by a lender is the risk that the borrower will suffer
illiquidity – an inability to raise cash to pay its obligations. This condition can arise
for many reasons, one of which is a loss of ability to borrow new funds to pay off
existing creditors.

Whatever the underlying cause, however, illiquidity manifests itself as an excess of

current cash payments due, over cash currently available.

The current ratio gauges the risk of this occurring by comparing the claims against
the company that will become payable during the current operating cycle (current
liabilities) with the assets that are already in the form of cash or that will be
converted to cash during the current operating cycle (current assets).

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Current ratio expresses current assets (assets expected to be consumed or converted

into cash within one year) in relation to current liabilities (liabilities falling due
within one year). So the formula is…

Current ratio = Current assets / Current liabilities

A higher ratio indicates a higher level of liquidity (i.e., a greater ability to meet short-
term obligations). A current ratio of 1.0 would indicate that the book value of a
company’s current assets exactly equals the book value of its current liabilities.

A lower ratio indicates less liquidity, implying a greater reliance on operating cash
flow and outside financing to meet short-term obligations.

Solving the above formula for Hero Motocorp’s FY13 numbers, we get…

Current ratio = Current assets / Current liabilities = 5,077 / 4,170 = 1.2

Just as a reference, for Bajaj Auto, the current ratio for FY13 stood at 1.5, which
indicates slightly better liquidity than that of Hero Motocorp.

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Here are current ratios of a few large Indian firms from across industries…

2. Quick Ratio
Apart from current ratio, investors and analysts also apply a more stringent test of
liquidity by calculating the quick ratio, or acid test ratio.

This considers the quick assets – only cash and current assets that can be most
quickly converted to cash (marketable securities and receivables). The formula is…

Quick Ratio = (Cash + Current Investments

+ Receivables) / Current Liabilities

The quick ratio reflects the fact that current assets like inventory might not be easily
and quickly converted into cash, and furthermore, that a company would probably
not be able to sell all of its inventory for an amount equal to its carrying value,
especially if it were required to sell the inventory quickly.

In situations where inventories are illiquid (as indicated, for example, by low
inventory turnover ratios), the quick ratio may be a better indicator of liquidity than
the current ratio.

Now, besides looking at the ratio between current assets and current liabilities, it is
also useful, when assessing a company’s ability to meet its near-term obligations, to
consider the difference between the two, which is termed “working capital”, which we
studied in the previous lesson on Activity Ratios.

3. Cash Conversion Cycle

This metric of liquidity, which is not in fact a ratio, indicates the amount of time that
elapses from the point when a company invests in working capital until the point at
which the company collects cash. The formula is…

Cash Conversion Cycle = Inventory Days

+ Receivables Days – Payables Days

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Pulling data from the previous lesson where we had

calculated Hero Motocorp’s inventory, receivables,
and payables days, the result is…

Hero’s FY13 Cash Conversion Cycle = 13.6 + 7.2 –

43.1 = -22.3

So, Hero has a negative cash conversion cycle, which

simply means that its cash collection (from its
customers) happens faster than its cash payments (to
suppliers of raw materials etc.) This is akin to having
a regular supply of zero-interest loan from suppliers
to run day-to-day operations.

Most other companies do not enjoy such a benefit. In the typical course of events, a
merchandising company (like a retailer) acquires inventory on credit, incurring trade
payable. The company then sells that inventory on credit, increasing trade receivable.
Afterwards, it pays out cash to settle its trade payable, and it collects cash in
settlement of its trade receivable.

Anyways, a short (or negative, like in case of Hero Motocorp) cash conversion cycle
indicates greater liquidity. A short cycle also implies that the company needs to
finance its inventory and trade receivable for only a short period of time.

A long cash conversion cycle indicates lower liquidity; it implies that the company
must finance its inventory and trade receivable for a longer period of time, possibly
indicating a need for a higher level of capital to fund current assets.

Now to answer what is long and what is short, it’s important to do a comparison vis-
a-vis a competitor. So, when I compare Hero Motocorp’s negative cash collection
cycle of -22 to Bajaj Auto’s -22, I see this as an industry norm and thus Hero is not in
such an enviable position in the industry as it seems. It, along with Bajaj Auto,
definitely has a great liquidity position vis-a-vis other companies.

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II. Solvency Ratios

While Liquidity Ratios help measure a company’s ability to meet short-term
obligations (how quickly assets are converted into cash), Solvency Ratios help assess
a company’s ability to fulfil its long-term debt obligations.

Assessment of a company’s ability to pay its long-term obligations (i.e., to make

interest and principal payments) generally includes an in-depth analysis of the
components of its financial structure.

Solvency ratios provide information regarding the relative amount of debt in the
company’s capital structure and the adequacy of earnings and cash flow to cover
interest expenses and other fixed charges (such as lease or rental payments) as they
come due.

As an investor, you must seek to understand a company’s use of debt for several main
reasons. One reason is that the amount of debt in a company’s capital structure is
important for assessing the company’s risk and return characteristics, specifically its
financial leverage.

Leverage is a magnifying effect that results from the use of fixed costs – costs that
stay the same within some range of activity – and can take two forms: operating
leverage and financial leverage.

Operating leverage results from the use of fixed costs in conducting the company’s
business. It magnifies the effect of changes in sales on operating income. Profitable
companies may use operating leverage because when revenues increase, with
operating leverage, their operating income increases at a faster rate. The explanation
is that, although variable costs will rise proportionally with revenue, fixed costs will
not.

When financing a company (i.e., raising capital for it), the use of debt constitutes
financial leverage because interest payments are essentially fixed financing costs. As
a result of interest payments, a given percent change in EBIT results in a larger
percent change in earnings before taxes (EBT).

Thus, financial leverage tends to magnify the effect of changes in EBIT on returns
flowing to equity holders.

Assuming that a company can earn more on the funds than it pays in interest, the
inclusion of some level of debt in a company’s capital structure may lower a
company’s overall cost of capital and increase returns to equity holders.

However, a higher level of debt in a company’s capital structure increases the risk of
default and results in higher borrowing costs for the company to compensate lenders
for assuming greater credit risk.

While analyzing financial statements, you must aim to understand levels and trends
in a company’s use of financial leverage (debt) in relation to past practices and the
practices of peer companies. You must also be aware of the relationship between
operating leverage and financial leverage.

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The greater a company’s use of operating leverage, the greater the risk of the
operating income stream available to cover debt payments; operating leverage can
thus limit a company’s capacity to use financial leverage.

A company’s relative solvency is fundamental to valuation of its debt securities and

its creditworthiness. Finally, understanding a company’s use of debt can provide you
with insight into the company’s future business prospects because management’s
decisions about financing often signal their beliefs about a company’s future.

Anyways, here are a few important solvency ratios you must understand and use
while analyzing a business…

As you can see from the table above, solvency ratios are primarily of two types –

1. Debt ratios focus on the balance sheet and measure the amount of debt
capital relative to capital.
2. Coverage ratio – interest coverage – focuses on the income statement and
measure the ability of a company to cover its debt payments.

All of these ratios are useful in assessing a company’s solvency and, therefore, in
evaluating the quality of a company’s bonds and other debt obligations. Let us
understand each of these solvency ratios.

1. Debt-to-Assets Ratio
This ratio measures the percentage of total assets financed with debt. For example, a
debt-to-assets ratio of 0.60 or 60% indicates that 60% of the company’s assets are
financed with debt. Generally, higher debt means higher financial risk and thus
weaker solvency.

2. Debt-to-Capital Ratio
This ratio measures the percentage of a company’s capital (debt plus equity)
represented by debt. As with the previous ratio, a higher ratio generally means higher
financial risk and thus indicates weaker solvency.

3. Debt-to-Equity Ratio
This ratio measures the amount of debt capital relative to equity capital.
Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates
weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity,
which is equivalent to a debt-to-capital ratio of 50%.

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4. Financial Leverage Ratio

This ratio (often called simply as leverage ratio) measures the amount of total assets
supported for each one money unit of equity. For example, a value of 3 for this ratio
means that each Rs 1 of equity supports Rs 3 of total assets.

The higher the financial leverage ratio, the more leveraged the company is in the
sense of using debt and other liabilities to finance assets. This ratio is often defined
in terms of average total assets and average total equity.

5. Interest Coverage
This ratio measures the number of times a company’s EBIT (earnings before interest
and tax) could cover its interest payments. A higher interest coverage ratio indicates
stronger solvency, offering greater assurance that the company can service its debt
(i.e., bank debt, bonds) from operating earnings.

Let me now demonstrate the use of solvency ratios in evaluating the creditworthiness
of a company that has debt on its Balance Sheet, say Tata Motors.

Evaluating Solvency Ratios

Example 1: The following data are gathered from Tata Motors’ FY12 and FY13
annual reports:

1. Calculate the company’s financial leverage ratio for FY13, and interpret what
you see.
2. What are the company’s debt-to-assets, debt-to-capital, and debt-to-equity
ratios for the two years?
3. Is there any visible trend over these two years?

Solution for Q. 1:
Average assets = 144,931 + 170,026 = 157,479
Average total equity = 32,699 + 37,637 = 35,168
Thus, financial leverage = 157,479 / 35,168 = 4.5

For FY13, every Rs 1 in total equity supported Rs 4.5 in total assets, on average.

Solution for Q. 2: Here are the debt ratios of Tata Motors for the two years…

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Solution for Q. 3: On all three metrics, the company’s level of debt has remained
stable. They have, in fact, marginally improved. If they were to decline further, it
would suggest an improved solvency for Tata Motors, and thus lower risk of default
on obligations.

Example 2: Let us now assess the solvency ratios for Suzlon. We would however
calculate Suzlon’s solvency ratios for FY06 to FY08, when the stock was on fire…

As you can assess from the trend in numbers above, Suzlon’s balance sheet was
worsening with each passing year, starting FY06.

All its three debt ratios worsened. The company’s financial leverage also increased
from 1.9 in FY06 to 3.4 in FY08, suggesting that the company was using increased
amount of debt and other liabilities to finance every Rs 1 of its assets.

So, just a study of Suzlon’s solvency ratios would have led many investors in it to save
their hard-eared money from going away with the wind!

Anyways, this completes the lesson on understanding a company’s liquidity and

solvency using a few important ratios.

In the third and concluding part of Ratio Analysis, I will cover the Profitability Ratios
in detail.

Profitability is a key determinant of a company’s overall value and the value of the

to be a key focus of their analytical efforts.

A company’s profitability reflects its competitive position in the market, and by

extension, the quality of its management.

We will study all that in the next lesson.

Exercise
Download the FY12 and FY13 annual reports of Voltas and Blue Star – India’s
biggest air-conditioning companies – and calculate these ratios for both the
companies for both the years, using formulae I’ve explained in the lesson above.

1. Liquidity Ratios

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Current Ratio
Quick Ratio
Cash Conversion Cycle

2. Solvency Ratios
Debt-to-Assets Ratio
Debt-to-Capital Ratio
Debt-to-Equity Ratio
Financial Leverage Ratio
Interest coverage

Then, write you observations on the trends you see for both the companies on each of
these ratios, and also suggest which one you find better on these parameters of
liquidity and solvency.

I could have shared with you my excel with in-built formulae, but I would suggest
you create your own excel file and save all the formulae as we are discussing in these
lessons. When you create the formulae yourself, you will remember them better, and
thus understand them better.

So get going, and share your results of the above task on the Mastermind forum
via this link.

Further Reading
Financial Statement Analysis ~ Martin Fridson
Intermediate Accounting For Dummies ~ Maire Loughran

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