Definition Of
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Definition of 'Liquidity Ratios'
A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
Investopedia explains 'Liquidity Ratios'
Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.
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Related Definitions
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Current Assets
1. A balance sheet account that represents the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. Current assets ...
Read More »
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Current Liabilities
A company's debts or obligations that are due within one year. Current liabilities appear on the company's balance sheet and include short term debt, accounts payable, accrued ... Read More »
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Liquidity
1. The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. ... Read More »
Read more: http://www.investopedia.com/terms/l/liquidityratios.asp#ixzz0RzCcGkBV
Definition and Explanation:
Current ratio is also known as working capital ratio or 2 : 1 ratio. It is the ratio of total current assets to total current liabilities. Current assets are those which are usually converted into cash or consumed with in short period (say one year). Current liabilities are required to be paid in short period (say one year). Examples of current assets and current liabilities are as follows: Current Assets Cash Bank Stock: Raw materials Work-in-progress Finished goods Short-term investments Sundry debtors (less provision) Current Liabilities Sundry creditors Bills payable Outstanding expenses Bank overdraft Taxes etc., payable Dividend payable Short-term advances
Bills receivable Recoverable advances, Prepaid Expenses In case where bank overdraft is permanent feature and minimum investment in stock cannot be en-cashed the same should not be treated as current items. But normally these are include under the current items.
Formula of Current Ratio:
Current ratios is calculated by using the following formula: Current ratio = Current assets / current liabilities
Interpretation of Current Ratio:
Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities. High current ratio finds favor with short-term creditors whereas low ratio causes concern to them. An increase in the current ratio reflects improvement in the liquidity position of the business while the decrease signals that there has been a deterioration in the liquidity position of the business. As a convention 2 :1 is regarded as satisfactory level i.e. current assets should be almost double than the current liabilities. The idea is to provide for loss in the value of current assets due to probable decrease in the market value and to offered for any possible delay in the realization of current assets. However there is no scientific reasoning behind 2 : 1 norm. Current ratio compares only the quantity of current assets rather than the quality of assets. A high current ratio though considered to be desirable may prove to be otherwise due to following reasons: 1. In case of slow moving stocks, these will pile up and will lead to higher ratio. 2. In case of slow collection of trade debts it will also lead to higher ratio. 3. Cash and bank balance may be more then necessary consequently significant portion may remain idle which is not at all desirable: 4. On the other hand if the current ratio is low due to following reasons it is again undesirable: 5. Lack of sufficient funds to meet current obligations and 6. Trading level beyond the capacity of the business. Before arriving at any conclusion based on the interpretation of current ratio the following factors should be considered:
Nature of Business:
Public utility undertakings like electricity boards, transport corporations, municipal committees have the legal force to collect their dues in time so even a low current ratio need not cause any worry but normal trading business must have satisfactory current ratio.
Nature of Product:
A business dealing in consumer goods will require better current ratio as compared to a business which is dealing in durable or capital goods.
Reputation of the Business also Influences the Requirement of Liquidity:
A business having better reputation can do with small cash and bank balance as compared to comparatively unknown business house. It is so because well-known business shall enjoy favorable terms of credit.
Seasonal Influence:
In a business where raw material is a seasonal commodity like wheat or sugarcane, it will require the purchase of annual consumption in the season itself, thus, requiring higher investment in stock as compared to the business where purchases can be spread over evenly throughout the year.
Example:
From the following balance sheet, calculate current ratio: Liabilities Equity share capital Reserve and surplus Debentures Trade creditors Bills payable Bank overdraft Outstanding expenses Income tax payable Proposed dividends $ 1,50,000 50,000 60,000 6,000 5,000 5,000 1,000 30,000 10,000 Assets Land & building Plant & machinery Goodwill Cash Investments (Short-term Bills receivable Sundry debtors Less provision Inventories Work in progress 2,90,000 Solution: Current assets are: cash, investments, bills receivable, sundry debtors (net), inventories and work-in-progress. 22,000 2,000 20,000 30,000 15,000 2,90,000 $ 100,000 80,000 20,000 5,000 15,000 5,000
$5,000 + 15,000 + 5,000 + 22,000 - 2,000 + 30,000 + 15,000 = $90,000. Current liabilities are trade creditors, bills payable, bank overdraft, outstanding expenses, income tax payable and proposed dividend. $6,000+ 5,000+ 5,000+1,000+3,000+10,000 = $30,000 Current ratio = Current assets/Current liabilities 90,000 / 30,000 3:1 This means that for every $1 worth of current liability there are current assets worth $3. It also means that the firm will be able to pay off its current liabilities in full even if current assets realizable value is 1/3rd of its book value.
Working capital position
For investors, the strength of a company's balance sheet can be evaluated by examining three broad categories of investment quality: working capital adequacy, asset performance and capitalization structure. In this article, we'll start with a comprehensive look at how best to evaluate the investment quality of a company's working capital position. In simple terms, this entails measuring the liquidity and managerial efficiency related to a company's current position. The analytical tool employed to accomplish this task will be a company's cash conversion cycle. Don¶t be Mislead by Faulty Analysis To start this discussion, let's first correct some commonly held, but erroneous, views on a company's current position, which simply consists of the relationship between its current assets and its current liabilities. Working capital is the difference between these two broad categories of financial figures and is expressed as an absolute dollar amount. Despite conventional wisdom, as a stand-alone number, a company's current position has little or no relevance to an assessment of its liquidity. Nevertheless, this number is prominently reported in corporate financial communications such as the annual report and also by investment research services. Whatever its size, the amount of working capital sheds very little light on the quality of a company's liquidity position. Another piece of conventional wisdom that needs correcting is the use of the current ratio and, its close relative, the acid test or quick ratio. Contrary to popular perception, these analytical tools don't convey the evaluative information about a company's liquidity that an investor needs to know. The ubiquitous current ratio, as an indicator of liquidity, is seriously flawed because it's conceptually based on a company's liquidation of all its current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going
concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio is misleading. (For related reading, see The Dynamic Current Ratio, Working Capital Works and Do Your Investments Have Short-Term Health?) A simplistic, but accurate, comparison of two companies' current positions will illustrate the weakness in relying on the current ratio and a working capital number as liquidity indicators: Liquidity Measures Current Assets Current Liabilities Working Capital Current Ratio Company ABC $600 $300 $300 2:1 Company XYZ $300 $300 $0 1:1
At first glance, company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio and a working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio and no working capital. However, what if both companies' current liabilities have an average payment period of 30 days; company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days). Company XYZ's customers pay in cash, and its inventory turns over 24 times a year (every 15 days). In this contrived example, company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company XYZ¶s seemingly tight current position is much more liquid because of its quicker cash conversion. Measuring a Company¶s Liquidity the Right Way The cash conversion cycle (also referred to as CCC or the operating cycle) is the analytical tool of choice for determining the investment quality of two critical assets - inventory and accounts receivable. The CCC tells us the time (number of days) it takes to convert these two important assets into cash. A fast turnover rate of these assets is what creates real liquidity and is a positive indication of the quality and the efficient management of inventory and receivables. By tracking the historical record (five to 10 years) of a company's CCC and comparing it to competitor companies in the same industry (CCCs will vary according to the type of product and customer base), we are provided with an insightful indicator of a balance sheet's investment quality. (For a more comprehensive discussion of the CCC, see Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.) Briefly stated, the cash conversion cycle is comprised of three standard, so-called activity ratios relating to the turnover of inventory, trade receivables and trade payables. These components of the CCC can be expressed as a number of times per year or as a number of days. Using the latter indicator provides a more literal and coherent time measurement that is easily understood. The cash conversion cycle formula looks like this:
Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) ± Days Payable Outstanding (DPO) = CCC Here's how the components are calculated: Dividing average inventories by cost of sales per day (cost of sales/365) = days inventory outstanding (DIO). Dividing average accounts receivables by net sales per day (net sales/365) = days sales outstanding (DSO). Dividing average accounts payables by cost of sales per day (cost of sales/365) = days payables outstanding (DPO). Liquidity is King One collateral observation is worth mentioning here. Investors should be alert to spotting liquidity enhancers in a company's financial information. For example, for a company that has non-current investment securities, there is typically a secondary market for the relatively quick conversion of all or a high portion of these items to cash. Also, unused committed lines of credit - usually mentioned in a note to the financials on debt or in the management discussion and analysis (MD&A) section of a company's annual report - can provide quick access to cash. The old adage that "cash is king" is as important for investors evaluating a company's investment qualities as it is for the managers running the business. A liquidity squeeze is worse than a profit squeeze. A key management function is to make sure that a company's receivable and inventory positions are managed efficiently. This means ensuring an adequate level of product availability and providing appropriate payment terms, while at the same time making sure that working capital assets don't tie up undue amounts of cash. This is a balancing act for managers, but an important one. It is important because with high liquidity, a company can take advantage of price discounts on cash purchases, reduce short-term borrowings, benefit from a top commercial credit rating and take advantage of market opportunities. The cash conversion cycle and its component parts are useful indicators of a company's true liquidity. In addition, the performance of DIO and DSO is a good indicator of management's ability to handle the important inventory and receivable assets. For related reading, see In Position and Measuring Company Efficiency. by Richard Loth Richard Loth has more than three decades of international experience in banking (Citibank, Industrial National Bank, and Bank of Montreal), corporate financial consulting, and non-profit development assistance programs. During the past 12 years, he has been a registered investment adviser and a published author of books and publications on investing. Currently, he devotes his professional activities to educational endeavors, writing and lecturing, aimed at helping individual investors improve their investing know-how (see www.lothinvest.com) More from Investopedia
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Working Capital Ratio (Current Ratio)
Current Liabilities Indicates if a firm has enough short-term assets to cover its immediate liabilities. Things to remember If the ratio is less than one then they have negative working capital. A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.
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Current Assets
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[Click on the image(s) above to see the financial statements]
For Cory's Tequila Co. $4,615 = 1.54 $3,003 This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient, Cory's Tequila Co. seems to be comfortably in this area. If you wanted to take this ratio a step further then you could try the Acid Test/Quick Ratio - it is a more strenuous version of the W/C, indicating whether liabilities could be paid without selling inventory.
Account
Ratio Analysis: Conclusion
There is a lot to be said for valuing a company, it is no easy task. I hope that we have helped shed some light on this topic, and that you will use this information to make educated investment decisions. If you have any other questions about fundamental analysis please don't hesitate to contact us.
Let's recap what we've learned: y y Financial reports are published quarterly and annually. Ratios on their own don't really tell us a whole lot, but when we compare them against previous years numbers, other companies, industry averages, or the economy in general it can reveal a lot! Every ratio has it's variations, some people exclude things that others include. Use what you feel comfortable with, but be sure to have consistency when comparing against other companies.
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Calculate the Gross Operating Cycle
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Paige Turner
Paige Turner started writing professionally in 2009. Her articles on business, health, technology and travel have been published on various websites ever since. She holds a Master of Science in engineering from New York University.
By Paige Turner, eHow Contributor
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Current ratios are lower for shorter operating cycles.
Flag this photo A normal operating cycle includes the purchase or manufacture of inventory with credit purchases (accounts payable), the sale of inventory with credit sales (accounts receivable) and the payment of cash to suppliers and customers. It is a measure of the time taken to complete the purchase, sell the inventory and collect the cash. The perpetual inventory system keeps a running account of the available inventory. The periodic system of inventory measures inventory levels at periodic intervals. The gross operating cycle calculation does not take creditor deferral periods into account.
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Current Ratio Calculate My Salary
Difficulty: Moderate
Instructions
1.
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1
Calculate days inventory outstanding or DIO using the following formula: Days inventory outstanding = (average inventory / cost of goods sold) * 365 DIO is a measure of the number of days inventory was turned into sales.
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2
Calculate daily sales outstanding or DSO using the following formula:
Daily sales outstanding = (average accounts receivable / total credit sales) * 365 DSO is a measure of the age of the accounts receivable account.
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3
Calculate days payable outstanding or DPO or using the following formula: Days payable outstanding = (average accounts payable / cost of goods sold) * 365 DPO is a measure of the days taken by the company to pay off its accounts payable.
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4
Combine the values determined in Steps 1-3 to calculate the gross operating cycle using the following formula: Operating cycle = DIO + DSO - DPO (in days)
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Question: What is net working capital and how is it measured? Answer:
Net working capital is a financial metric a business owner can use in order to help measure the cash and operating liquidity position of the business firm. The net working capital metric is directly related to the current ratio. If you look at the calculation of the current ratio, you see that you use the same balance sheet data to calculate net working capital. Here is the calculation for Net Working Capital: Current Assets - Current Liabilities = Net Working Capital. If a business firm has current assets of $200 and current liabilities of $100, then:
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Net Working Capital = Current Assets - Current Liabilities =$200 - $100 =Net Working Capital=$100
This firm can pay its short-term debt obligations and still have $100 left over as a cash or operating liquidity cushion. It has twice the current assets ($200) as current liabilities ($100). Compare this to the current ratio. If you calculate the current ratio for this example, you would use the current ratio formula:
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Current Ratio = Current Assets/Current Liabilities $200/$100 = 2.00X Current ratio = 2.00X
You can see the relationship between the two financial metrics. Cash management and the management of operating liquidity is important for the survival of the business firm. A firm can make a profit, but if they have a problem with their cash position, they won't survive. This is why it is important for a business owner to use all the financial metrics and measures available to manage liquidity and cash.
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Back: What is the quick ratio and how is it used? Forward: What is the burn rate and how is it used? Tutorial: An Analysis of a Company's Liquidity Position Using Financial Ratios
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Financial Ratio Analysis - Working Capital Management 1: Liquidity Working Capital Management 1: Liquidity
Working capital management is concerned with making sure we have exactly the right amount of money and lines of credit available to the business at all times. In part 1 of our look at working capital management we will look at the liquidity ratios. Cash is the life-blood of any business, no matter how large or small. If a business has no cash and no way of getting any cash, it will have to close down. It's that simple! Following on from this we can see that if a business has no idea of its liquidity and working capital position, it could be in serious trouble.
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Ratio Analysis 3: Working Capital Management 1: Liquidity o Liquidity ratios o The Current Ratio: Activity 9 - Vodafone Current Ratio The Acid Test ratio Activity 10 : Vodafone Acid Test o An ideal ratio? Additional question 12 Additional question 13 Additional question 14 Section Index | Previous | Next | Next Section | Section Map
Submitted by bized on Thu, 30/01/2003 - 13:00
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About Working Capital Turnover
The Working Capital Turnover ratio measures the company''''s Net Sales from the Working Capital generated.
If Working Capital Turnover increases over time:
An increasing Working Capital Turnover is usually a positive sign, showing the company is more able to generate sales from its Working Capital.
If Working Capital Turnover decreases over time:
A decreasing Working Capital Turnover is usually a negative sign, showing the company is less able to generate sales from its Working Capital.
If Working Capital Turnover stays the same over time:
An unchanged Working Capital Turnover may indicate the company''s ability to generate sales from its Working Capital has remained the same.
al Ration Analysis » Financial Ratio Analysis - Liquidity ratios
Financial Ratio Analysis - Liquidity ratios Liquidity ratios
Current Assets: Current Liabilities
(Current Assets-Stocks): Current Liabilities The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in almost the whole of ratio analysis are also the simplest to use and to learn.
Financial Ratio Analysis - The Current Ratio The Current Ratio
The current ratio is also known as the working capital ratio and is normally presented as a real ratio. That is, the working capital ratio looks like this: Current Assets: Current Liabilities = x: y eg 1.75: 1 The Carphone Warehouse is our business of choice, so here is the information to help us work out its current ratio. Consolidated Balance Sheet 31 March 2001 25 March 2000 £'000 Total Current Assets Creditors: Amounts falling due within one year 315,528 222,348 £'000 171,160 173,820
As we saw in the brief review of accounts section with Tesco's financial statements, the phrase current liabilities is the same as Creditors: Amounts falling due within one year. Here's the table to fill in. OK, so we've done this one for you! Current Ratio For the Carphone Warehouse 31 March 2001 Current Assets: Current Liabilities 315,528: 222,348 1.42: 1 25 March 2000 Current Assets: Current Liabilities 171,160: 173,820 0.98: 1 Maths revision. How did we get 1.42: 1 for the year ended 31 March 2001? All we did was to divide the current assets by the current liabilities and that gives us: current assets 315,528 = = 1.42 current liabilities 222,348 so we automatically know that our ratio is 1.42: 1
The same with the year before: current assets 171,160 = = 0.98 current liabilities 173,820 so the ratio is 0.98: 1
Financial Ratio Analysis - The Acid Test Ratio The Acid Test Ratio
The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that stocks are sometimes a problem because they can be difficult to sell or use. That is, even though a supermarket has thousands of people walking through its doors every day, there are still items on its shelves that don't sell as quickly as the supermarket would like. Similarly, there are some items that will sell very well. Nevertheless, there are some businesses whose stocks will sell or be used slowly and if those businesses needed to sell some of their stocks to try to cover an emergency, they would be disappointed. Engineering companies can have their materials in stock for as much as 9 months to a year; a greengrocer should have his stocks for no longer than 4 or 5 days - a good greengrocer anyway. We'll look at the stock turnover ratio in detail later but here's the acid test ratio for the Carphone Warehouse. Acid Test Ratio = (Current Assets - Stocks) : Current Liabilities We can take the figures we need from the current ratio section and then do the calculations. Here are the acid test ratios for the year ended 31 March 2001: Fill in this table and discuss what you find: Acid Test Ratio For Carphone Warehouse 31 March 2001 Current Assets - Stocks: Current Liabilities _____: _____ ___: 1 25 March 2000 Current Assets - Stocks: Current Liabilities _____: _____ ___: 1
Did you get this? We need to put the current and acid test ratios side-by-side to help us to understand what is happening to the business: Comparison Current Acid Test 2001 2000 1.42: 1 0.98: 1 1.18: 1 0.69: 1
The fact that the differences between the current and acid test ratios are not too large tells us that the Carphone Warehouse stocks are not that large either. The stocks are worth around £52 million in 2001; but since current assets are £315 million, that's not a huge level of stock holdings. Additionally, the acid test ratio has increased over the two year period, meaning that the Carphone Warehouse has a stronger liquidity position than it had before. Normally that is a good thing.
Definition of 'Liquidity Ratios'
A class of financial metrics that is used to determine a company's ability to pay off its shortterms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
Investopedia explains 'Liquidity Ratios'
Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern
Definition of 'Working Capital Turnover'
A measurement comparing the depletion of working capital to the generation of sales over a given period. This provides some useful information as to how effectively a company is using its working capital to generate sales.
Investopedia explains 'Working Capital Turnover'
A company uses working capital (current assets - current liabilities) to fund operations and purchase inventory. These operations and inventory are then converted into sales revenue for the company. The working capital turnover ratio is used to analyze the relationship between the money used to fund operations and the sales generated from these operations. In a general sense, the higher the working capital turnover, the better because it means that the company is generating a lot of sales compared to the money it uses to fund the sales. For example, if a company has current assets of $10 million and current liabilities of $9 million, its working capital is $1 million. When compared to sales of $15 million, the working capital turnover ratio for the period is 15 ($15M/$1M). When used in fundamental analysis, this ratio can be compared to that of similar companies or to the company's own historical working capital turnovers.
Debt-to-equity ratio
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The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.[1] Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.
Contents
[hide]
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1 Usage 2 Formula 3 Background 4 Example 5 See also 6 References
[edit] Usage
Preferred shares can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares. When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD. The composition of equity and debt and its influence on the value of the firm is much debated and also described in the Modigliani-Miller theorem. Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable, although some will make adjustments to include or exclude certain items from the formal financial statements. Adjustments are sometimes also made to, for example, exclude intangible assets, and this will affect the formal equity; debt to equity (dequity) will therefore also be affected. Financial economists and academic papers will usually refer to all liabilities as debt, and the statement that equity plus liabilities equals assets is therefore an accounting identity (it is, by definition, true). Other definitions of debt to equity may not respect this accounting identity, and should be carefully compared.
[edit] Formula
D/E = Debt(liabilities)/equity
(Sometimes only interest-bearing long-term debt is used instead of total liabilities in the calculation) A similar ratio is debt-to-capital (D/C), where capital is the sum of debt and equity:
D/C = total liabilities / total capital = debt / (debt + equity)
The relationship between D/E and D/C is:
D/C = D/(D+E) = D/E / (1 + D/E)
The debt-to-total assets (D/A) is defined as
D/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)
It is a problematic measure of leverage, because an increase in non-financial liabilities reduces this ratio.[2] Nevertheless, it is in common use. In the financial industry (particularly banking), a similar concept is equity to total assets (or equity to risk-weighted assets), otherwise known as capital adequacy.
[edit] Background
On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical:
A=D+E E = A D or D = A E.
Debt to equity can also be reformulated in terms of assets or debt:
D/E = D /(A D) = (A E) / E.
[edit] Example
General Electric Co. ([1])
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Debt / equity: 4.304 (total debt / stockholder equity) (340/79). Note: This is often presented in percentage form, for instance 430.4. Other equity / shareholder equity: 7.177 (568,303,000/79,180,000) Equity ratio: 12% (shareholder equity / all equity) (79,180,000/647,483,000)
[edit] See also
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Financial ratio Debt-to-capital ratio
[edit] References
1. ^ Peterson, Pamela (1999). Analysis of Financial Statements. New York: Wiley. p. 92. ISBN 1883249597. 2. ^ Welch, Ivo. A Bad Measure of Leverage: The Financial-Debt-To-Asset Ratio. SSRN. SSRN 931675. [hide]
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Definition of 'Debt/Equity Ratio'
A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation. Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial
statements as well as corporate ones.
Investopedia explains 'Debt/Equity Ratio'
A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.
A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
Investopedia explains 'Liquidity Ratios'
Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.
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Related Definitions
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Current Assets
1. A balance sheet account that represents the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. Current assets ...
Read More »
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Current Liabilities
A company's debts or obligations that are due within one year. Current liabilities appear on the company's balance sheet and include short term debt, accounts payable, accrued ... Read More »
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Liquidity
1. The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. ... Read More »
Read more: http://www.investopedia.com/terms/l/liquidityratios.asp#ixzz0RzCcGkBV
Definition and Explanation:
Current ratio is also known as working capital ratio or 2 : 1 ratio. It is the ratio of total current assets to total current liabilities. Current assets are those which are usually converted into cash or consumed with in short period (say one year). Current liabilities are required to be paid in short period (say one year). Examples of current assets and current liabilities are as follows: Current Assets Cash Bank Stock: Raw materials Work-in-progress Finished goods Short-term investments Sundry debtors (less provision) Current Liabilities Sundry creditors Bills payable Outstanding expenses Bank overdraft Taxes etc., payable Dividend payable Short-term advances
Bills receivable Recoverable advances, Prepaid Expenses In case where bank overdraft is permanent feature and minimum investment in stock cannot be en-cashed the same should not be treated as current items. But normally these are include under the current items.
Formula of Current Ratio:
Current ratios is calculated by using the following formula: Current ratio = Current assets / current liabilities
Interpretation of Current Ratio:
Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities. High current ratio finds favor with short-term creditors whereas low ratio causes concern to them. An increase in the current ratio reflects improvement in the liquidity position of the business while the decrease signals that there has been a deterioration in the liquidity position of the business. As a convention 2 :1 is regarded as satisfactory level i.e. current assets should be almost double than the current liabilities. The idea is to provide for loss in the value of current assets due to probable decrease in the market value and to offered for any possible delay in the realization of current assets. However there is no scientific reasoning behind 2 : 1 norm. Current ratio compares only the quantity of current assets rather than the quality of assets. A high current ratio though considered to be desirable may prove to be otherwise due to following reasons: 1. In case of slow moving stocks, these will pile up and will lead to higher ratio. 2. In case of slow collection of trade debts it will also lead to higher ratio. 3. Cash and bank balance may be more then necessary consequently significant portion may remain idle which is not at all desirable: 4. On the other hand if the current ratio is low due to following reasons it is again undesirable: 5. Lack of sufficient funds to meet current obligations and 6. Trading level beyond the capacity of the business. Before arriving at any conclusion based on the interpretation of current ratio the following factors should be considered:
Nature of Business:
Public utility undertakings like electricity boards, transport corporations, municipal committees have the legal force to collect their dues in time so even a low current ratio need not cause any worry but normal trading business must have satisfactory current ratio.
Nature of Product:
A business dealing in consumer goods will require better current ratio as compared to a business which is dealing in durable or capital goods.
Reputation of the Business also Influences the Requirement of Liquidity:
A business having better reputation can do with small cash and bank balance as compared to comparatively unknown business house. It is so because well-known business shall enjoy favorable terms of credit.
Seasonal Influence:
In a business where raw material is a seasonal commodity like wheat or sugarcane, it will require the purchase of annual consumption in the season itself, thus, requiring higher investment in stock as compared to the business where purchases can be spread over evenly throughout the year.
Example:
From the following balance sheet, calculate current ratio: Liabilities Equity share capital Reserve and surplus Debentures Trade creditors Bills payable Bank overdraft Outstanding expenses Income tax payable Proposed dividends $ 1,50,000 50,000 60,000 6,000 5,000 5,000 1,000 30,000 10,000 Assets Land & building Plant & machinery Goodwill Cash Investments (Short-term Bills receivable Sundry debtors Less provision Inventories Work in progress 2,90,000 Solution: Current assets are: cash, investments, bills receivable, sundry debtors (net), inventories and work-in-progress. 22,000 2,000 20,000 30,000 15,000 2,90,000 $ 100,000 80,000 20,000 5,000 15,000 5,000
$5,000 + 15,000 + 5,000 + 22,000 - 2,000 + 30,000 + 15,000 = $90,000. Current liabilities are trade creditors, bills payable, bank overdraft, outstanding expenses, income tax payable and proposed dividend. $6,000+ 5,000+ 5,000+1,000+3,000+10,000 = $30,000 Current ratio = Current assets/Current liabilities 90,000 / 30,000 3:1 This means that for every $1 worth of current liability there are current assets worth $3. It also means that the firm will be able to pay off its current liabilities in full even if current assets realizable value is 1/3rd of its book value.
Working capital position
For investors, the strength of a company's balance sheet can be evaluated by examining three broad categories of investment quality: working capital adequacy, asset performance and capitalization structure. In this article, we'll start with a comprehensive look at how best to evaluate the investment quality of a company's working capital position. In simple terms, this entails measuring the liquidity and managerial efficiency related to a company's current position. The analytical tool employed to accomplish this task will be a company's cash conversion cycle. Don¶t be Mislead by Faulty Analysis To start this discussion, let's first correct some commonly held, but erroneous, views on a company's current position, which simply consists of the relationship between its current assets and its current liabilities. Working capital is the difference between these two broad categories of financial figures and is expressed as an absolute dollar amount. Despite conventional wisdom, as a stand-alone number, a company's current position has little or no relevance to an assessment of its liquidity. Nevertheless, this number is prominently reported in corporate financial communications such as the annual report and also by investment research services. Whatever its size, the amount of working capital sheds very little light on the quality of a company's liquidity position. Another piece of conventional wisdom that needs correcting is the use of the current ratio and, its close relative, the acid test or quick ratio. Contrary to popular perception, these analytical tools don't convey the evaluative information about a company's liquidity that an investor needs to know. The ubiquitous current ratio, as an indicator of liquidity, is seriously flawed because it's conceptually based on a company's liquidation of all its current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going
concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio is misleading. (For related reading, see The Dynamic Current Ratio, Working Capital Works and Do Your Investments Have Short-Term Health?) A simplistic, but accurate, comparison of two companies' current positions will illustrate the weakness in relying on the current ratio and a working capital number as liquidity indicators: Liquidity Measures Current Assets Current Liabilities Working Capital Current Ratio Company ABC $600 $300 $300 2:1 Company XYZ $300 $300 $0 1:1
At first glance, company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio and a working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio and no working capital. However, what if both companies' current liabilities have an average payment period of 30 days; company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days). Company XYZ's customers pay in cash, and its inventory turns over 24 times a year (every 15 days). In this contrived example, company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company XYZ¶s seemingly tight current position is much more liquid because of its quicker cash conversion. Measuring a Company¶s Liquidity the Right Way The cash conversion cycle (also referred to as CCC or the operating cycle) is the analytical tool of choice for determining the investment quality of two critical assets - inventory and accounts receivable. The CCC tells us the time (number of days) it takes to convert these two important assets into cash. A fast turnover rate of these assets is what creates real liquidity and is a positive indication of the quality and the efficient management of inventory and receivables. By tracking the historical record (five to 10 years) of a company's CCC and comparing it to competitor companies in the same industry (CCCs will vary according to the type of product and customer base), we are provided with an insightful indicator of a balance sheet's investment quality. (For a more comprehensive discussion of the CCC, see Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.) Briefly stated, the cash conversion cycle is comprised of three standard, so-called activity ratios relating to the turnover of inventory, trade receivables and trade payables. These components of the CCC can be expressed as a number of times per year or as a number of days. Using the latter indicator provides a more literal and coherent time measurement that is easily understood. The cash conversion cycle formula looks like this:
Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) ± Days Payable Outstanding (DPO) = CCC Here's how the components are calculated: Dividing average inventories by cost of sales per day (cost of sales/365) = days inventory outstanding (DIO). Dividing average accounts receivables by net sales per day (net sales/365) = days sales outstanding (DSO). Dividing average accounts payables by cost of sales per day (cost of sales/365) = days payables outstanding (DPO). Liquidity is King One collateral observation is worth mentioning here. Investors should be alert to spotting liquidity enhancers in a company's financial information. For example, for a company that has non-current investment securities, there is typically a secondary market for the relatively quick conversion of all or a high portion of these items to cash. Also, unused committed lines of credit - usually mentioned in a note to the financials on debt or in the management discussion and analysis (MD&A) section of a company's annual report - can provide quick access to cash. The old adage that "cash is king" is as important for investors evaluating a company's investment qualities as it is for the managers running the business. A liquidity squeeze is worse than a profit squeeze. A key management function is to make sure that a company's receivable and inventory positions are managed efficiently. This means ensuring an adequate level of product availability and providing appropriate payment terms, while at the same time making sure that working capital assets don't tie up undue amounts of cash. This is a balancing act for managers, but an important one. It is important because with high liquidity, a company can take advantage of price discounts on cash purchases, reduce short-term borrowings, benefit from a top commercial credit rating and take advantage of market opportunities. The cash conversion cycle and its component parts are useful indicators of a company's true liquidity. In addition, the performance of DIO and DSO is a good indicator of management's ability to handle the important inventory and receivable assets. For related reading, see In Position and Measuring Company Efficiency. by Richard Loth Richard Loth has more than three decades of international experience in banking (Citibank, Industrial National Bank, and Bank of Montreal), corporate financial consulting, and non-profit development assistance programs. During the past 12 years, he has been a registered investment adviser and a published author of books and publications on investing. Currently, he devotes his professional activities to educational endeavors, writing and lecturing, aimed at helping individual investors improve their investing know-how (see www.lothinvest.com) More from Investopedia
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Working Capital Works Financial Statements: Introduction
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Reading The Balance Sheet Understanding The Cash Conversion Cycle Stock-Picking Strategies: Introduction
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Working Capital Ratio (Current Ratio)
Current Liabilities Indicates if a firm has enough short-term assets to cover its immediate liabilities. Things to remember If the ratio is less than one then they have negative working capital. A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.
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Current Assets
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[Click on the image(s) above to see the financial statements]
For Cory's Tequila Co. $4,615 = 1.54 $3,003 This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient, Cory's Tequila Co. seems to be comfortably in this area. If you wanted to take this ratio a step further then you could try the Acid Test/Quick Ratio - it is a more strenuous version of the W/C, indicating whether liabilities could be paid without selling inventory.
Account
Ratio Analysis: Conclusion
There is a lot to be said for valuing a company, it is no easy task. I hope that we have helped shed some light on this topic, and that you will use this information to make educated investment decisions. If you have any other questions about fundamental analysis please don't hesitate to contact us.
Let's recap what we've learned: y y Financial reports are published quarterly and annually. Ratios on their own don't really tell us a whole lot, but when we compare them against previous years numbers, other companies, industry averages, or the economy in general it can reveal a lot! Every ratio has it's variations, some people exclude things that others include. Use what you feel comfortable with, but be sure to have consistency when comparing against other companies.
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Calculate the Gross Operating Cycle
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Paige Turner
Paige Turner started writing professionally in 2009. Her articles on business, health, technology and travel have been published on various websites ever since. She holds a Master of Science in engineering from New York University.
By Paige Turner, eHow Contributor
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Current ratios are lower for shorter operating cycles.
Flag this photo A normal operating cycle includes the purchase or manufacture of inventory with credit purchases (accounts payable), the sale of inventory with credit sales (accounts receivable) and the payment of cash to suppliers and customers. It is a measure of the time taken to complete the purchase, sell the inventory and collect the cash. The perpetual inventory system keeps a running account of the available inventory. The periodic system of inventory measures inventory levels at periodic intervals. The gross operating cycle calculation does not take creditor deferral periods into account.
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Current Ratio Calculate My Salary
Difficulty: Moderate
Instructions
1.
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1
Calculate days inventory outstanding or DIO using the following formula: Days inventory outstanding = (average inventory / cost of goods sold) * 365 DIO is a measure of the number of days inventory was turned into sales.
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2
Calculate daily sales outstanding or DSO using the following formula:
Daily sales outstanding = (average accounts receivable / total credit sales) * 365 DSO is a measure of the age of the accounts receivable account.
o
3
Calculate days payable outstanding or DPO or using the following formula: Days payable outstanding = (average accounts payable / cost of goods sold) * 365 DPO is a measure of the days taken by the company to pay off its accounts payable.
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4
Combine the values determined in Steps 1-3 to calculate the gross operating cycle using the following formula: Operating cycle = DIO + DSO - DPO (in days)
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Question: What is net working capital and how is it measured? Answer:
Net working capital is a financial metric a business owner can use in order to help measure the cash and operating liquidity position of the business firm. The net working capital metric is directly related to the current ratio. If you look at the calculation of the current ratio, you see that you use the same balance sheet data to calculate net working capital. Here is the calculation for Net Working Capital: Current Assets - Current Liabilities = Net Working Capital. If a business firm has current assets of $200 and current liabilities of $100, then:
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Net Working Capital = Current Assets - Current Liabilities =$200 - $100 =Net Working Capital=$100
This firm can pay its short-term debt obligations and still have $100 left over as a cash or operating liquidity cushion. It has twice the current assets ($200) as current liabilities ($100). Compare this to the current ratio. If you calculate the current ratio for this example, you would use the current ratio formula:
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Current Ratio = Current Assets/Current Liabilities $200/$100 = 2.00X Current ratio = 2.00X
You can see the relationship between the two financial metrics. Cash management and the management of operating liquidity is important for the survival of the business firm. A firm can make a profit, but if they have a problem with their cash position, they won't survive. This is why it is important for a business owner to use all the financial metrics and measures available to manage liquidity and cash.
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Back: What is the quick ratio and how is it used? Forward: What is the burn rate and how is it used? Tutorial: An Analysis of a Company's Liquidity Position Using Financial Ratios
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Financial Ratio Analysis - Working Capital Management 1: Liquidity Working Capital Management 1: Liquidity
Working capital management is concerned with making sure we have exactly the right amount of money and lines of credit available to the business at all times. In part 1 of our look at working capital management we will look at the liquidity ratios. Cash is the life-blood of any business, no matter how large or small. If a business has no cash and no way of getting any cash, it will have to close down. It's that simple! Following on from this we can see that if a business has no idea of its liquidity and working capital position, it could be in serious trouble.
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Ratio Analysis 3: Working Capital Management 1: Liquidity o Liquidity ratios o The Current Ratio: Activity 9 - Vodafone Current Ratio The Acid Test ratio Activity 10 : Vodafone Acid Test o An ideal ratio? Additional question 12 Additional question 13 Additional question 14 Section Index | Previous | Next | Next Section | Section Map
Submitted by bized on Thu, 30/01/2003 - 13:00
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About Working Capital Turnover
The Working Capital Turnover ratio measures the company''''s Net Sales from the Working Capital generated.
If Working Capital Turnover increases over time:
An increasing Working Capital Turnover is usually a positive sign, showing the company is more able to generate sales from its Working Capital.
If Working Capital Turnover decreases over time:
A decreasing Working Capital Turnover is usually a negative sign, showing the company is less able to generate sales from its Working Capital.
If Working Capital Turnover stays the same over time:
An unchanged Working Capital Turnover may indicate the company''s ability to generate sales from its Working Capital has remained the same.
al Ration Analysis » Financial Ratio Analysis - Liquidity ratios
Financial Ratio Analysis - Liquidity ratios Liquidity ratios
Current Assets: Current Liabilities
(Current Assets-Stocks): Current Liabilities The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in almost the whole of ratio analysis are also the simplest to use and to learn.
Financial Ratio Analysis - The Current Ratio The Current Ratio
The current ratio is also known as the working capital ratio and is normally presented as a real ratio. That is, the working capital ratio looks like this: Current Assets: Current Liabilities = x: y eg 1.75: 1 The Carphone Warehouse is our business of choice, so here is the information to help us work out its current ratio. Consolidated Balance Sheet 31 March 2001 25 March 2000 £'000 Total Current Assets Creditors: Amounts falling due within one year 315,528 222,348 £'000 171,160 173,820
As we saw in the brief review of accounts section with Tesco's financial statements, the phrase current liabilities is the same as Creditors: Amounts falling due within one year. Here's the table to fill in. OK, so we've done this one for you! Current Ratio For the Carphone Warehouse 31 March 2001 Current Assets: Current Liabilities 315,528: 222,348 1.42: 1 25 March 2000 Current Assets: Current Liabilities 171,160: 173,820 0.98: 1 Maths revision. How did we get 1.42: 1 for the year ended 31 March 2001? All we did was to divide the current assets by the current liabilities and that gives us: current assets 315,528 = = 1.42 current liabilities 222,348 so we automatically know that our ratio is 1.42: 1
The same with the year before: current assets 171,160 = = 0.98 current liabilities 173,820 so the ratio is 0.98: 1
Financial Ratio Analysis - The Acid Test Ratio The Acid Test Ratio
The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that stocks are sometimes a problem because they can be difficult to sell or use. That is, even though a supermarket has thousands of people walking through its doors every day, there are still items on its shelves that don't sell as quickly as the supermarket would like. Similarly, there are some items that will sell very well. Nevertheless, there are some businesses whose stocks will sell or be used slowly and if those businesses needed to sell some of their stocks to try to cover an emergency, they would be disappointed. Engineering companies can have their materials in stock for as much as 9 months to a year; a greengrocer should have his stocks for no longer than 4 or 5 days - a good greengrocer anyway. We'll look at the stock turnover ratio in detail later but here's the acid test ratio for the Carphone Warehouse. Acid Test Ratio = (Current Assets - Stocks) : Current Liabilities We can take the figures we need from the current ratio section and then do the calculations. Here are the acid test ratios for the year ended 31 March 2001: Fill in this table and discuss what you find: Acid Test Ratio For Carphone Warehouse 31 March 2001 Current Assets - Stocks: Current Liabilities _____: _____ ___: 1 25 March 2000 Current Assets - Stocks: Current Liabilities _____: _____ ___: 1
Did you get this? We need to put the current and acid test ratios side-by-side to help us to understand what is happening to the business: Comparison Current Acid Test 2001 2000 1.42: 1 0.98: 1 1.18: 1 0.69: 1
The fact that the differences between the current and acid test ratios are not too large tells us that the Carphone Warehouse stocks are not that large either. The stocks are worth around £52 million in 2001; but since current assets are £315 million, that's not a huge level of stock holdings. Additionally, the acid test ratio has increased over the two year period, meaning that the Carphone Warehouse has a stronger liquidity position than it had before. Normally that is a good thing.
Definition of 'Liquidity Ratios'
A class of financial metrics that is used to determine a company's ability to pay off its shortterms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
Investopedia explains 'Liquidity Ratios'
Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern
Definition of 'Working Capital Turnover'
A measurement comparing the depletion of working capital to the generation of sales over a given period. This provides some useful information as to how effectively a company is using its working capital to generate sales.
Investopedia explains 'Working Capital Turnover'
A company uses working capital (current assets - current liabilities) to fund operations and purchase inventory. These operations and inventory are then converted into sales revenue for the company. The working capital turnover ratio is used to analyze the relationship between the money used to fund operations and the sales generated from these operations. In a general sense, the higher the working capital turnover, the better because it means that the company is generating a lot of sales compared to the money it uses to fund the sales. For example, if a company has current assets of $10 million and current liabilities of $9 million, its working capital is $1 million. When compared to sales of $15 million, the working capital turnover ratio for the period is 15 ($15M/$1M). When used in fundamental analysis, this ratio can be compared to that of similar companies or to the company's own historical working capital turnovers.
Debt-to-equity ratio
From Wikipedia, the free encyclopedia Jump to: navigation, search
The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.[1] Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.
Contents
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1 Usage 2 Formula 3 Background 4 Example 5 See also 6 References
[edit] Usage
Preferred shares can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares. When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD. The composition of equity and debt and its influence on the value of the firm is much debated and also described in the Modigliani-Miller theorem. Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable, although some will make adjustments to include or exclude certain items from the formal financial statements. Adjustments are sometimes also made to, for example, exclude intangible assets, and this will affect the formal equity; debt to equity (dequity) will therefore also be affected. Financial economists and academic papers will usually refer to all liabilities as debt, and the statement that equity plus liabilities equals assets is therefore an accounting identity (it is, by definition, true). Other definitions of debt to equity may not respect this accounting identity, and should be carefully compared.
[edit] Formula
D/E = Debt(liabilities)/equity
(Sometimes only interest-bearing long-term debt is used instead of total liabilities in the calculation) A similar ratio is debt-to-capital (D/C), where capital is the sum of debt and equity:
D/C = total liabilities / total capital = debt / (debt + equity)
The relationship between D/E and D/C is:
D/C = D/(D+E) = D/E / (1 + D/E)
The debt-to-total assets (D/A) is defined as
D/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)
It is a problematic measure of leverage, because an increase in non-financial liabilities reduces this ratio.[2] Nevertheless, it is in common use. In the financial industry (particularly banking), a similar concept is equity to total assets (or equity to risk-weighted assets), otherwise known as capital adequacy.
[edit] Background
On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical:
A=D+E E = A D or D = A E.
Debt to equity can also be reformulated in terms of assets or debt:
D/E = D /(A D) = (A E) / E.
[edit] Example
General Electric Co. ([1])
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Debt / equity: 4.304 (total debt / stockholder equity) (340/79). Note: This is often presented in percentage form, for instance 430.4. Other equity / shareholder equity: 7.177 (568,303,000/79,180,000) Equity ratio: 12% (shareholder equity / all equity) (79,180,000/647,483,000)
[edit] See also
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Financial ratio Debt-to-capital ratio
[edit] References
1. ^ Peterson, Pamela (1999). Analysis of Financial Statements. New York: Wiley. p. 92. ISBN 1883249597. 2. ^ Welch, Ivo. A Bad Measure of Leverage: The Financial-Debt-To-Asset Ratio. SSRN. SSRN 931675. [hide]
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Related terms
Definition of 'Debt/Equity Ratio'
A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation. Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial
statements as well as corporate ones.
Investopedia explains 'Debt/Equity Ratio'
A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.
