Leverage and Liquidity Ratios and Measures

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There are several calculated values based upon data found on the Balance Sheet and Cash Flow Statement that provide insights on leverage and liquidity. 

Quick reference

Leverage and Liquidity Ratios and Measures

There are several calculated values based upon data found on the Balance Sheet and Cash Flow Statement that provide insights on leverage and liquidity. 

When to Use Leverage and Liquidity Ratios and Measures

When analysing business health, these measures are used.  They are often tracked to determine trends.

Instructions

  • There are two leverage ratios discussed in this section.  Operating managers seldom are asked to measure or monitor these because they are dealing with corporate debt and treasury function.  However, sometimes in order to impact ratios that are considered unacceptable, operating managers may be asked to initiate or curtail projects and operations.
  • The Debt Ratio is the ratio of Total Debt divided by Total Assets.  Depending upon the industry, acceptable values can vary.  
  • The Debt Ratio is used to evaluate risk.  It shows how a company is growing the asset base.  Are assets being funded through debt or through equity?
  • High values of Debt Ratio are risky because the company may not have the assets to generate enough cash to support the repayment of the debt.  A Debt Ratio greater than one indicates the company does not have enough assets to pay off its debt and that the owner’s equity is negative.
  • Low values lead to questions as to why the company is not using debt to grow and manage the business.  Depending upon the business and industry, this may be considered good or bad.
  • The debt to equity ratio is the Total Debt divided by Total Equity.  There are several variations of this formula used in some industries and countries.  The most popular alternative is to use Total Liabilities divided by Total Equity.  The difference being whether the Accounts Payable are included or not.
  • This provides insight into how the asset base was created.  Essentially asking the question, “Did the company borrow its growth or earn its growth?”
  • A high value of debt to equity is considered risky.  What is considered his is based upon the industry.  For instance, most manufacturing companies try to stay below 1, while banks are much higher, often over 3.
  • There is one liquidity measure to discuss and this is one upon which operating managers decisions have a major impact. This is Free Cash Flow.
  • Free Cash Flow is the Cash from Operating Activities minus the Cash used to fund Capital Expenditures.  Both of these values can be obtained from the cash flow statement.
  • This measure indicates whether the company is able to fund the capital investment tied to its strategy execution through ongoing operations?  If unable, the company must borrow money or change its strategy.
  • The Free Cash Flow that is generated can be either used to pay down debt or returned to investors in the form of dividends.
  • Operating managers have a major impact on the amount of Cash from Operating Activities based upon the efficiency of how well they manage the business.  They also are normally responsible for the acquisition and utilization of capital equipment and assets. 

 

Hints and Tips

  • Make sure you know which measure is being referred to when discussion discussing debt ratio and debt-to-equity ratio.
  • Timing of transactions will have significant impact on Free Cash Flow
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  • 00:01 Hi, I'm Ray Sheen.
  • 00:05 I'd like to review a few leverage and liquidity measures.
  • 00:08 Now, as operating managers we don't deal with these very much, but
  • 00:12 some of the directives we receive from finance are based upon what is happening
  • 00:16 in these measures.
  • 00:17 I will start with the debt ratio.
  • 00:21 This ratio can be calculated from values found on the balance sheet.
  • 00:26 This is total debt divided by total assets.
  • 00:29 Some people will include all the liabilities with the debt, but
  • 00:33 the formal definition is just debt divided by assets.
  • 00:36 This is a leverage measure to indicate how the assets of the business were acquired.
  • 00:41 Was money borrowed to obtain the assets, or were the assets purchased
  • 00:45 from money generated through investment and operations?
  • 00:48 If this number gets over one, there is a problem.
  • 00:51 In fact, if it even grows to the point where it is near that value,
  • 00:54 the company should be worried.
  • 00:56 When there are not enough assets to cover the debt,
  • 00:59 the company could find itself in bankruptcy is the debt is called.
  • 01:03 However, a very low debt ratio value is not necessarily good.
  • 01:07 It could indicate that the company is not trying to aggressively grow and
  • 01:10 leverage its asset base.
  • 01:12 The ideal value will vary from industry to industry and
  • 01:15 vary based on the risk tolerance of the investors.
  • 01:19 This ratio is primarily used by investors, not operating managers.
  • 01:23 A few years ago there was a famous bankruptcy of the Enron Corporation.
  • 01:27 Their financial reports contain fraudulent data.
  • 01:30 When it was revealed that their true debt ratio was 68% not 40% banks
  • 01:35 started calling the loans.
  • 01:37 They couldn't sell off assets fast enough to pay their debt, and
  • 01:40 they went into bankruptcy.
  • 01:42 Another ratio from the balance sheet is the debt equity ratio.
  • 01:46 This is a ratio of total debt divided by total equity.
  • 01:50 This ratio is actually calculated several different ways by different
  • 01:53 financial gurus.
  • 01:54 Another approach that is occasionally used is to divide total liabilities,
  • 01:58 by total equity.
  • 02:00 Use whichever definition your company prefers.
  • 02:03 This ratio shows whether the asset base was created using debt or equity.
  • 02:07 In essence, answering the question for
  • 02:09 a company, did we borrow our business growth, or earn our business growth?
  • 02:14 Borrowing is not bad, but high values are considered risky.
  • 02:19 Most manufacturing companies try to stay below a value of one.
  • 02:22 However banks and financial institutions will often be up at two, or three,
  • 02:26 or even higher.
  • 02:28 Again, this is used mostly by investors Not by operating managers.
  • 02:31 Although sometimes financial decisions to improve these leverage ratios
  • 02:35 will impact the operational decisions.
  • 02:38 The last measure I want to discuss is more of a liquidity measure, and
  • 02:42 is called Free cash flow.
  • 02:45 This measure can be derived from a number of different values on the earning
  • 02:48 statement and balance sheet, or
  • 02:50 it can just be calculated directly from the cash flow statement.
  • 02:53 I'm into doing things simply when possible, so
  • 02:56 I will use the cash flow statement approach.
  • 02:59 Free cash flow is the cash from operating activities minus the cash used for
  • 03:03 capital expenditures.
  • 03:05 Some individuals will say it is the cash from operating activities
  • 03:08 minus the cash from all investing activities.
  • 03:12 If your business does not invest in financial investments,
  • 03:15 Then the only investments are capital expenditures and it is the same result.
  • 03:19 However, to be clear you should not include investments
  • 03:23 into financial securities as part of this calculation.
  • 03:26 This is a great operational measurement and
  • 03:29 I know that some business unit managers are tracked on this measure.
  • 03:32 It basically checks to make sure your operations are efficient enough to pay all
  • 03:36 the bills and generate the cash needed for investing, and strategic assets.
  • 03:40 But more efficiently the operations are managed,
  • 03:43 the higher the level of cash from operating activities.
  • 03:47 The money from the free cash flow can be used to pay off debt,
  • 03:51 distribute to share holders, or to build up funds for
  • 03:54 a major strategic initiative, such as purchasing another company.
  • 04:00 These measures, the debt ratio, debt to equity ratio,
  • 04:03 and free cash flow, provide insight into business leverage and liquidity.

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