Leverage ratios
A high level of debt is risky, especially in a downturn when revenues and profitability shrink. Leverage ratios measure the extent of leverage and the ability to meet the obligations it creates. When businesses create assets aggressively out of borrowed money and those assets fail to generate the expected revenues and profits, the liability still has to be met, and without the ability to pay lenders a business may face bankruptcy.
Formula · Debt to equity (D/E)
D/E = Total adjusted debt / Net worth
- Adjusted debt includes all interest-bearing liabilities, short-term and long-term, plus gaps on pension deficits and convertibles. Some investors use total debt; others use only long-term debt or net debt, which is total debt minus cash.
- Prudent investors avoid extremely high debt. On the most conservative basis a D/E of 1 or less is the benchmark; then industry, the company's track record, capital required and project details decide.
- Bharti FY2019: 12,87,036 / 8,49,480 = 1.52x.
Formula · Interest coverage ratio
Interest coverage = EBIT / Interest expense
- How many times earnings cover the interest obligation, before considering principal repayment. High means the business is in a comfortable zone.
- Below 1 or negative means earnings are less than interest, or negative while interest obligations exist. Such businesses borrow or infuse equity to run the show and face significant problems unless they turn around soon: Kingfisher Airlines is the example.
Liquidity ratios
Can the business honour its obligations as and when they arise? Two simple measures answer that.
Formula · Current ratio
Current ratio = Current assets / Current liabilities
- Also known as the working capital ratio. Above 1 means current assets exceed current liabilities. It measures the ability to meet short-term liabilities, which is what the sample question asks.
- Its working capital elements carry signals: high finished goods inventory may mean sales are slowing; high raw material inventory may mean poor production planning; high receivables mean the company sells on credit and is not realising cash; high payables may show strength in getting the best credit terms from suppliers.
- Companies that take cash on sales and pay on credit run a current ratio below 1. That is not a red flag; it is a very good situation in which the company's working is funded by its customers.
- A high ratio may indicate poor management of inventory, receivables and cash; a very low ratio points to deeper analysis. Bharti FY2019: 3,29,057 / 9,30,549 = 0.35. Optically bad, but companies with high bargaining power over customers and suppliers often manage, and prefer, negative working capital because it is an interest-free obligation.
Formula · Quick ratio
Quick ratio = (Current assets - Inventories) / Current liabilities
- The more stringent version: it drops current assets that cannot be converted into cash immediately, inventories being the prominent example.
- Accounts receivable, cash and investments in liquid funds stay in. Higher means better availability of liquid assets for immediate obligations.
Efficiency ratios
Efficiency in operations improves capital allocation and, with it, profitability and return ratios.
Formula · Accounts receivable turnover
Receivable turnover = Revenue / Average accounts receivable
- How fast sales convert to cash. Higher is better: only a small portion of revenue sits as credit. Low means the company gives too easy credit or struggles to recover money from distributors and clients.
Formula · Accounts payable turnover
Payable turnover = Purchases / Accounts payable
- How much of purchases are on credit. High payables in the denominator give a low ratio, meaning long credit periods with suppliers.
- Hard to conclude from alone: long credit may reflect bargaining power or an inability to pay. Even bargaining power may not be good in the long run because suppliers dislike it; good companies focus on paying on time as much as on collecting on time.
Formula · Asset turnover
Asset turnover = Net sales / Total assets
- How many times assets are churned to generate revenue. Idle assets deploy capital without earning; continuously used assets lift revenue and profit. Higher is better.
- Also used in DuPont analysis to decompose ROE.
Formula · Inventory turnover
Inventory turnover = Sales / Inventory
- How many times inventory is rolled over. Higher is better: slow inventory locks money, and perishable goods deteriorate.
- High for FMCG companies, low for capital goods companies.
Exam trapLow is not always bad, high is not always good
A current ratio below 1 is fine when customers fund the business; a current ratio far above 1 can mean idle cash and bloated stock. A low payable turnover can mean strength or distress. The exam likes answers that treat one reading as automatically good or bad; the syllabus keeps saying the context decides.
Take these into the exam
- Leverage: D/E = total adjusted debt / net worth, where adjusted debt includes all interest-bearing liabilities short and long term, pension deficits and convertibles (some use total debt, long-term debt only, or net debt = total debt minus cash). A D/E of 1 or less is the most conservative benchmark, then industry, track record, capital needs and project details decide. Bharti FY2019: 1.52x. Interest coverage = EBIT / interest expense: high is comfortable; below 1 or negative means earnings cannot cover interest and the firm borrows or raises equity to run the show, as Kingfisher did.
- Liquidity: current ratio = current assets / current liabilities, also called the working capital ratio; above 1 means current assets exceed current liabilities. High finished goods inventory may mean slowing sales, high raw material inventory poor production planning, high receivables credit sales not converted to cash, high payables strong credit terms from suppliers. Companies that collect cash on sales and pay suppliers on credit run below 1 without any red flag; their working is funded by customers. Bharti: 0.35, and firms with bargaining power often prefer negative working capital as an interest-free obligation. Quick ratio = (current assets minus inventories) / current liabilities, the stricter test, keeping receivables, cash and liquid fund investments.
- Efficiency: accounts receivable turnover = revenue / average accounts receivable, higher is better, low means easy credit or collection trouble; accounts payable turnover = purchases / accounts payable, low means long supplier credit, which may reflect bargaining power or inability to pay, and good companies pay on time; asset turnover = net sales / total assets, higher is better and also feeds DuPont; inventory turnover = sales / inventory, higher is better, high for FMCG and low for capital goods, since slow inventory locks money and perishables deteriorate.
- A high current ratio may signal poor management of inventory, receivables and cash; a very low one calls for deeper analysis. Turnover ratios need context: a number alone rarely settles whether the cause is strength or distress.