This post is the last in a series covering financial ratios. In previous posts, we discussed ratios which measure profitability and working capital efficiency. In this post, we cover credit ratios. Credit ratios help investors, lenders, and managers determine a firm’s ability to satisfy debt obligations.
Naturally, lenders are concerned about a firm’s ability to service its debts while maintaining current productive capacity. Equity investors are also concerned with a firm’s credit position. This is because common equity represents the most junior claim on a company’s assets and cash flows. Claims to creditors, suppliers, employees, tax agencies, and landlords are all senior to the claims of common shareholders. Common equity only has value if these senior claims can be satisfied.
Corporate managers monitor credit ratios to understand the firm’s additional borrowing capacity. If a firm is maintaining low borrowing capacity relative to assets and cash flows, the firm can finance growth through additional borrowing.
Credit ratios fall into one of three categories: liquidity ratios, solvency ratios, and coverage ratios.
Liquidity Ratios
Liquidity refers to assets which can convert to cash quickly and without significant impairment. Liquidity ratios provide a measure of a company’s ability to meet its short-term obligations with liquid resources.
A firm’s current liabilities are comprised of current financial liabilities and operating liabilities. Financial liabilities are amounts owed to the firm’s creditors (including lease obligations owed to landlords). The amount of financing liabilities recognized as current are those amounts due within the firm’s operating cycle (generally 12 months). Operating liabilities are amounts owed to vendors, employees, tax agencies, and customers – basically, amounts owed to everyone other than capital providers.
Not all current liabilities represent future outlays of cash. For example, when a company receives payment for work not yet performed, the company recognizes a liability called unearned revenue. As the company performs the work, it will recognize the revenue and reduce the unearned revenue account. In other words, some current liabilities represent obligations to deliver a product or service, rather than a future cash payment.
There are three key liquidity ratios: the current ratio, the quick ratio, and the cash ratio.
The current ratio compares the firm’s current assets against its current liabilities.
Current Ratio = Current Assets ÷ Current Liabilities
The current ratio is the amount of current assets for every $1 in current liabilities. The current ratio is the most generic and least useful of the three liquidity ratios. This is because current assets include things like prepaid expenses, which are not “sellable” assets and thus not available to pay down current liabilities.
A more useful liquidity measure is the quick ratio. The quick ratio excludes from the numerator certain “non sellable” current assets, such as prepaid expenses and unbilled revenue. In addition, the quick ratio excludes inventory since the firm must maintain a certain level of inventory to remain a sustainable enterprise. Rather, the quick ratio includes in the numerator only those assets which can quickly convert to cash.
Quick Ratio = (Cash + Short-Term Investments + Receivables) ÷ Current Liabilities
An even more conservative ratio is the cash ratio. The cash ratio focuses on the most liquid assets the firm has – namely cash and short-term debt instruments – to settle current obligations.
Cash Ratio = (Cash + Short-Term Investments) ÷ Current Liabilities
Solvency Ratios
Solvency refers to a firm’s ability to meet its total obligations. Solvency ratios compare a firm’s total assets against its total liabilities. Total liabilities include the non-current portion of debt (including lease obligations) and long-term operating and financial liabilities.
The most widely used solvency ratios are debt-to-assets, debt-to-tangible assets, long-term debt-to-total debt, and total assets-to-common equity.
The debt-to-assets ratio represents the proportion of the company’s assets financed by debt. The debt-to-assets ratio is total debt divided by total assets. The company’s total debt equals the sum of short-term debt, non-current debt, and lease obligations.
Debt-to-Assets = Total Debt ÷ Total Assets
We can also take the inverse of this ratio (total assets ÷ total debt), which represents the amount of assets per dollar of financing liabilities.
The debt-to-tangible assets eliminates intangible assets such as acquired goodwill. The debt-to-tangible assets is the total debt divided by the total amount of tangible assets.
Debt-to-Tangible Assets = Total Debt ÷ Total Assets
The long-term debt-to-total debt ratio represents the proportion of total debt which is due beyond the next twelve months (from the balance sheet date). This ratio is important as long-term debt is a more stable form of debt capital than short-term debt. The long-term debt-to-total debt ratio is noncurrent debt divided by total debt (including lease obligations).
Long-Term Debt-to-Total Debt = Noncurrent Debt ÷ Total Debt
The assets-to-common equity ratio, also called the leverage ratio, represents the assets the firm owns for every $1 of equity capital. The leverage ratio is total assets divided by common equity.
Leverage Ratio = Total Assets ÷ Common Equity
Coverage Ratios
Liquidity and solvency ratios provide an indication of the strength of a firm’s balance sheet – i.e., the resources the company controls relative to its financing and operating liabilities. Coverage ratios look at the ability to satisfy debt service out of current operations.
Coverage ratios compare a form of before-tax earnings or cash flow to total debt service. Most finance and accounting textbooks will use proxies such as EBITDA in the numerator. However, we prefer to use free cash flow in the numerator as it accounts for investments needed to maintain operating capacity.
We define free cash flow as follows:
Free cash flow = NOPAT + Depreciation and Amortization – Investments in Working Capital and Fixed Assets
NOPAT stands for net operating profits after taxes. It is the operating profit if the firm had no debt. To calculate operating profit, we first adjust the P&L for nonrecurring and extraordinary items. We then multiply the adjusted earnings before interest and taxes (EBIT) by one minus the tax rate.
NOPAT = EBIT x (1 – Tc)
We then add back depreciation and amortization charges, which are both noncash expenses.
When we create cash flow forecasts, we subtract out the investments in working capital (the increase in current operating assets over current operating liabilities) and fixed assets necessary to support the revenue growth which we are forecasting. However, for the purpose of coverage ratios, we are concerned with current operations. Thus, we only subtract maintenance capital expenditures (maintenance capex). Maintenance capex represents the average amount of spending to replace fixed assets and maintain current operating capacity. We calculate current free cash flow as follows:
Current Free Cash Flow = NOPAT – Depreciation and Amortization – Maintenance Capex
The three coverage ratios which we have found most useful are cash flow-to-interest expense, cash flow-to-total debt service, and cash flow-to-debt.
The cash flow-to-interest ratio compares the amount of current free cash flow to the amount of after-tax interest expense. This ratio tells us the amount of cash flow available to cover each dollar of interest expense. We calculate the ratio as current free cash flow divided by after-tax interest expense. We use after-tax interest expense because we are not accounting for the interest deductibility in the numerator.
Cash Flow-to-Interest = Current Free Cash Flow ÷ (Interest Expense x (1 – Tc))
The cash flow-to-total debt service ratio represents the amount of cash flow available to pay total debt service – i.e., principal and interest on outstanding borrowings. We calculate the ratio as current free cash flow divided by the sum of after-tax interest expense and principal payment.
Cash Flow-to-Debt Service = Current Free Cash Flow ÷ ([Interest Expense x (1 – Tc) + Principal)
The cash flow-to-debt ratio compares the amount of current free cash flow to the firm’s total financial liabilities. We do not include lease obligations in the denominator. This is because lease payments are expensed under US GAAP and therefore are included in the numerator. This ratio tells us the amount of cash flow that is available to pay down debt. We calculate the cash flow-to-debt ratio as current free cash flow minus after-tax interest expense, divided by total debt (current and noncurrent).
Cash Flow-to-Debt Ratio = (Current Free Cash Flow – [Interest expense x (1 – Tc)]) ÷ Total Debt
Conclusion
Credit ratios convey valuable information regarding a firm’s ability to adequately service its debts and remain operationally competitive. Credit ratios allow lenders, managers, and equity investors to determine the financial health of the business.
Like all ratios, managers, investors, and lenders should compare ratios against trends and industry averages.
