Financial ratios

Financial Ratios

Financial and accounting ratios are parameters calculated from the real data of our company that can guide tell us about the economic health or reveal problems that the simple reading of a balance sheet or a P & L may not detect.

We do not intend from here to make an in-depth study of all of them, but we will try to list and explain the most useful or common ones. In this blog we will talk about the most common ratios to measure the liquidity, or short-term solvency, of the company.

Liquidity is obviously a consequence of the profitability of the company and its proper functioning. This informs us about the company’s ability to react in case not only to face periodic debts already planned, but also situations that may arise suddenly.

Liquidity will also be a factor to be studied by, for example, financial institutions when granting loans. It will also alert us if we have an excess of liquidity that we could allocate to financial investments in the short or medium term, for example…

Immediate liquidity

Also known as “Cash Reason”

It provides us with the most immediate liquidity data, since it informs us about the ratio of those investments that the company can execute in liquidity in one or two days over the short-term debt.

It is obtained by dividing the cash (including those deposits with the possibility of immediate liquidity) by the current liabilities (short-term debt). The financial literature establishes a good 0.3 figure, although this may vary depending on the sector, company size, etc.

Acid reason or acid-rapid ratio

This ratio informs us about the company’s ability to meet short-term debt commitments.

Although there may be another formulation, the generally accepted one is to divide the difference between the current asset and the stock, between the current liability.

Again, the optimal data is relative, there is literature that sets it to 0.6 and another that is more inclined to a ratio close to 1 is optimal; The smaller it is compared to 1, the more possibilities there are of not being able to face obligations with third parties. However, a data well above one may indicate an excess of liquidity that could be used for financial investments in search of profitability. 

Other authors consider that this setting the optimal value around 1 is more appropriate for the following ratio.

Working capital

Within what this topic is, it is the most “popular”. Its calculation is very similar to the previous one, the ratio between current assets and liabilities.

It is another way of calculating the ability to deal with debts and obligations with third parties with the part of the asset that we can more easily convert into liquidity. As we mentioned in the previous point, a ratio close to 1 is considered adequate.

Coverage Ratios or Cash Flow on debt

The cash coverage ratio measures the ability of the business generated by the company to cope with the debt, in the short or long term.

This ratio is calculated by dividing Cash-Flow by total debt (long and short term).

Cash Flow is the result of adding to the final result of the company the concepts of depreciation and amortisation, which are accounting expenses, but do not involve liquidity. Lately, the Cash Flow concept is losing ground against EBITDA , which is calculated from the operating account (without financial results) and adds the concepts of taxes, depreciation and amortisation, for the same reason as in the previous paragraph.

The higher this ratio , the greater the capacity there will be to deal with the company’s debts.