Having looked at profitability ratios in our last article, today we shall look at the next article in the financial ratios series: Gearing/Liquidity ratios!
To start off with – let me explain the weird sounding names for this particular group of ratios.
What is liquidity?
Liquidity (from a business perspective) looks at how ‘liquid’ the business is. Liquidity here means the ability of a business to utilise their assets to pay off their debts. To pay off debts, assets generally need to be converted into cash (which is the most liquid of all assets).
So businesses with lots of cash and very little debt are said to be very ‘Liquid’ (because they can flow easily – get it?) and businesses with lots of fixed assets and lots of debt are said to be ‘illiquid’ (because apparently ‘solid’ doesn’t sound cool enough).
What is Gearing?
Gearing talks about how much debt a business has. If you think of a business as a machine, then debt are the gears that form up the moving parts of the business machine. Hence the word ‘Gearing’.
A business that has too little debt is said to be ‘under-geared’ – which means that the business may be missing out on opportunities to grow and expand due to lack of funding. A business that has too much debt is said to be ‘over-geared’ – which means that they may not be able to pay off that debt and might end up defaulting on their loans.
So using the ‘Gears’ analogy – a machine with too few gears may not be working at its peak efficiency and a machine with too many gears will have its gears jam up and block one another, crippling the machine in the process.
Now just so you know, the names gearing and liquidity ratios tend to be used interchangeably – but they all refer to the same thing, which is: The business’ ability to manage and service their debts.
Ok, now that I’ve explained the rationale behind those weird sounding names, let’s talk ratios!!
Let’s look at the first gearing/liquidity ratio:
The Current Ratio
The current ratio looks at the proportion of current assets a business holds as compared to its current liabilities. It measures the ability of a business to to service their current liabilities (that is: all debts which are payable within the financial year) with the current assets they have on hand (things like cash, customer debts, stock and inventory etc.).
The higher the current ratio, the easier it is for the business to pay off their debts. The lower the current ratio, the harder it is for the business to pay off their debts. Let’s say that a business has a current ratio of ‘1’ – this means that they have an equal amount of current assets to current liabilities – which means that if tomorrow ALL their current debt were to be made payable, they can cash out all of their current assets and be able to pay off all their debt.
The current ratio also comes in two other modified flavors which are:
The quick ratio
AND
The cash ratio
The Debt-Equity ratio
I’m sure by now you understand the relationship between Assets, Liabilities and Equity right? So you will also know that a business’ finances are made up of Debt and Equity. Generally speaking, equity is a safer and cheaper form of financing as compared to debt. Debt however is easier to access compared to equity.
The Debt-Equity ratio looks at the amount of debt your business holds in proportion to the amount of equity it has. The higher the number, the more debt your business has. Businesses with a lot of debt compared to their equity will have a debt-equity ratio of ‘1’ or higher whereas businesses with more equity than debt will have a debt-equity ratio of less than ‘1’.
A high debt-equity ratio means that a business is very reliant on debt and that if they cannot service their debt, the entire business will come crashing down. A low debt-equity ratio means that a business is less reliant on debt but they may be missing out on growth opportunities by not taking full advantage of debt financing.
There needs to be a balance between debt and equity finance and the Debt-Equity ratio looks to calculate that balance. That being said, new businesses will find that they have low debt-equity ratios due to their reliance on equity. As they grow larger, this debt-equity ratio starts to grow once they take on more debt to finance their growth. Generally speaking, for older, more well-established businesses, a debt-equity ratio of around ‘1’ is a healthy sign.
The Debt-Asset ratio
It looks similar to the debt-equity ratio, but the debt-asset ratio looks at the proportion of assets financed by debt. Simply put – the debt-asset ratio looks at how much of your assets are being supported by debt, directly and indirectly.
A higher debt-asset ratio indicates that a lot of your assets are financed by debt. A lower debt-asset ratio means that fewer assets are financed by debt. Generally speaking, the debt-asset ratio should never be higher than 1 (which means that your assets are 100% financed by debt). The only way it can get higher than 1 is if you have negative equity – which means that you are losing money in the business, which is NOT a very good indicator of business survival!
The debt-asset ratio is very handy because it shows you how reliant your business is on debt. If your debt-asset ratio is 0.5 – this means that you have about 50% of your assets financed by debt, with equity financing the other 50%. Generally speaking, the lower the debt-asset ratio, the better, because it shows that your business is not super-reliant on debt. That being said, for a business that is aiming to grow, they may want to obtain more debt finance to quickly drive business growth.
As with all other liquidity/gearing ratios – balance is key! Businesses starting out will have low debt-asset ratios and once they get larger, they might take on more debt and their debt-asset ratios will increase as well. It is important to keep an eye on that debt-asset ratio though – don’t let it get too high and most importantly, Don’t let it exceed ‘1’!!!
Now while a lot of these Liquidity/Gearing ratios might sound similar to each other – the main thing you want to remember is that businesses with a lot of debt tend to be quite risky, but at the same time, businesses with too little debt may not be trying hard enough to grow their business.
That’s it for Liquidity/Gearing ratios – the next time we come back to ratio analysis, we will look at efficiency ratios!