Understanding Activity, Liquidity, and Solvency Ratios | CFA Level I FSA

In this article, we’ll dive into three types of financial ratios that analysts frequently use: activity ratios, liquidity ratios, and solvency ratios. We’ll also explain how to compute, analyze, and interpret these ratios.

Types of Financial Ratios

In financial analysis, we can broadly classify ratios into five categories:

• Activity Ratios: Measure the efficiency of day-to-day tasks, like collecting receivables and managing inventory.
• Liquidity Ratios: Measure the company’s ability to meet short-term obligations.
• Solvency Ratios: Measure the company’s ability to meet long-term obligations. Also known as leverage and long-term debt ratios.
• Profitability Ratios: Measure the company’s ability to generate profits from its assets.
• Valuation Ratios: Measure the quantity of an asset or flow associated with ownership of a specified claim.

These categories aren’t mutually exclusive, but each ratio measures a different aspect of the company’s business. In this article, we’ll focus on activity, liquidity, and solvency ratios.

General Rules for Using Financial Ratios

Before diving into specific ratios, let’s discuss some general rules to keep in mind when working with financial statements:

• For a pure ratio using only income statement items, use values from the current income statement.
• For a pure ratio using only balance sheet items, use ending values from the current balance sheet.
• For a mixed ratio with items from different statements, use the average of the balance sheet item. To calculate a simple average, add the beginning and ending values and divide by 2.

Activity Ratios: Asset Utilization and Operating Efficiency

Activity ratios, also known as asset utilization or operating efficiency ratios, measure the efficiency of a firm in utilizing its assets. Efficiency directly impacts liquidity, so some activity ratios can also be used to assess liquidity.

Here are some common activity ratios:

• Total Asset Turnover Ratio: Measures the company’s efficiency in generating revenue with its assets. It’s calculated as revenue earned for the period divided by the average total assets. Higher ratios indicate greater efficiency.
• Fixed Asset Turnover Ratio: Measures the company’s efficiency in generating revenue from its investments in fixed assets. It’s calculated as the revenue earned for the period divided by the average net fixed assets (net of accumulated depreciation). Higher ratios are generally better, but fluctuations in the denominator can distort the ratio.
• Working Capital Turnover Ratio: Measures the company’s efficiency in managing its working capital. It’s calculated as the revenue earned for the period divided by the average working capital (current assets minus current liabilities). A high ratio indicates efficient working capital management, but near-zero or negative values can make this ratio difficult to interpret.
• Inventory Turnover Ratio: Measures the company’s efficiency in managing its inventory. It’s calculated as the cost of goods sold for the period divided by the average inventory.
• Receivable Turnover Ratio: Measures the company’s efficiency in managing its receivables. It’s calculated as the revenue for the period divided by the average receivables.
• Payables Turnover Ratio: Measures the company’s efficiency in managing its trade credit. It’s calculated as the purchases for the period divided by the average payables. Purchases can be calculated as ending inventory minus beginning inventory plus cost of goods sold.

These ratios can be inverted and multiplied by 365 to obtain the days of inventory on hand, days of sales outstanding, and number of days of payables. These values help us understand a firm’s operating cycle and cash conversion cycle.

Liquidity and Solvency Ratios

Liquidity ratios measure a company’s ability to meet its short-term obligations, while solvency ratios assess its ability to meet long-term obligations. Both are important for evaluating a company’s overall financial health. Let’s examine some common liquidity and solvency ratios:

• Current Ratio: Measures the company’s ability to pay its short-term liabilities with its short-term assets. It’s calculated as current assets divided by current liabilities. A higher ratio indicates better liquidity.
• Quick Ratio: Also known as the acid-test ratio, this measures the company’s ability to meet its short-term obligations using its most liquid assets (excluding inventory). It’s calculated as (current assets – inventory) divided by current liabilities. A higher ratio is better.
• Debt-to-Equity Ratio: Measures the company’s financial leverage by comparing its total debt to shareholders’ equity. It’s calculated as total debt divided by shareholders’ equity. A higher ratio indicates a higher level of debt relative to equity, which can be riskier.
• Debt Ratio: Measures the proportion of a company’s assets that are financed by debt. It’s calculated as total debt divided by total assets. A higher ratio means a larger portion of assets are financed by debt, which can indicate higher risk.

It’s essential to compare these ratios with industry norms and historical trends to understand a company’s financial position accurately.

Defensive Interval Ratio and Additional Liquidity Ratios

The defensive interval ratio measures a company’s ability to pay its expenses from existing liquid assets without any additional cash inflow. It is calculated by dividing the sum of the company’s quick assets by the average daily expenditures. A higher defensive interval ratio indicates better liquidity. Analysts should consider comparing this ratio to peer companies or the company’s historical data to determine if the company has sufficient cash inflows in the future to mitigate any liquidity concerns.

Other liquidity ratios to consider include the current ratio, quick ratio, and cash ratio, which we’ve discussed previously in the context of understanding balance sheets. These ratios offer additional insight into a company’s ability to meet its short-term obligations and are useful when assessing the overall liquidity position of a firm.

Solvency Ratios

Solvency ratios measure a company’s ability to meet its long-term obligations. These ratios include debt ratios (based on the balance sheet) and coverage ratios (based on the income statement). By examining solvency ratios, analysts can evaluate a company’s ability to meet its long-term debt and other obligations, providing insight into its overall financial stability.

Debt ratios measure the amount of debt relative to the company’s capital structure. Various debt ratios include debt-to-asset, debt-to-capital, and debt-to-equity ratios. Higher ratios typically indicate higher financial risk and weaker solvency. It is important to consider these ratios when assessing a company’s financial risk and long-term stability.

The financial leverage ratio measures the amount of total assets supported by each unit of equity. A higher ratio indicates greater leverage, which can impact the company’s overall risk profile. This ratio is particularly useful for understanding how much of a company’s total assets are supported by its equity, providing insight into the firm’s capital structure.

Income statement-based ratios, such as the interest coverage ratio and fixed charge coverage ratio, assess the company’s ability to manage its long-term obligations through its income stream. Higher coverage ratios indicate stronger solvency, providing greater assurance that the company can service its debt from its operating earnings. These ratios are particularly important for companies with significant debt or lease obligations, as they provide insight into the firm’s ability to meet these obligations over time.

Conclusion

In this second part on financial analysis techniques, we covered activity, liquidity, and solvency ratios. By examining these ratios, you can better understand a company’s efficiency, liquidity, and ability to meet its obligations. Comparing these ratios to industry standards and historical trends will provide a more comprehensive understanding of a company’s financial health.