Liquidity Ratios

While we have already discussed ratios that help you measure across firms the level of profitability and return, there are a final set of ratios that measure a firm's ability to pay certain obligations like debt, short-term loans and even dividends.

Debt-to-Equity Ratio

The level of a company's debt is another important indicator of its financial health. A firm that is dependent on debt to operate or expand loses flexibility in operating decisions because of the requirement to meet current debt obligations. If a company over-estimates its ability to manage its debt levels during an economic recession or cyclical low in its business cycle, the end results could include bankruptcy.

Debt to equity is calculated as total debt divided by equity (book value). When looking at a company's debt, it is important to do so in comparison with to its assets and overall size. It is also important to take the level of a firm's debt into consideration relative to the industry in which it operates. In some cases, a firm with a stable and reliable form of income such as utilities can often afford more debt than a firm with a highly cyclical business.

Interest Coverage Ratio

In addition to measuring a company's debt relative to its equity, measuring the firm's ability to make the required interest payments is paramount to avoiding potential bankruptcy. The ratio is calculated as:

Interest coverage ratio = Earnings before Interest and Taxes (Operating earnings) / Interest Expense

The higher the ratio, the more likely the company is to be able to meet its requirement to pay the required interest on issued bonds. A low ratio might indicate that the firm could have trouble meeting debt payments if sales at the firm were to decline.

Quick & Current Ratios

Similar to the ability to repay long-term debt is the ability to pay short-term financing needs back. When short-term debts come due, typically a firm will pay those debts using cash, marketable securities (stock, short-term bonds) or accounts receivables (cash due from customers). The two most common ratios for measuring a company's ability to repay short-term debt are the quick ratio and current ratio. They are calculated as follows:

Quick Ratio = (cash + marketable securities + accounts receivables) / current liabilities

Current Ratio = current assets / current liabilities

Payout Ratio

While not directly related to payments of debt, the payout ratio can be a valuable tool for the dividend investor. The payout ratio's primary focus is to determine what percentage of net income is being paid out as a dividend to stock holders. While appropriate ratios can vary from industry to industry the typical thought is that that a high percentage means that there is more risk that the current dividend may be not sustainable in the event that a company's earnings power is reduced. The calculation is as follows:

Dividend Payout Ratio = dividends / net income

The strategies described in this article are for information purposes only, and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision. Securities are subject to market fluctuation and may lose value.