2.1 Liquidity & Leverage Ratios

Liquidity Ratios: Can the Firm Pay Its Bills?

Liquidity ratios measure a company's ability to settle obligations coming due within one year. They compare short-term resources against short-term claims. Three are tested heavily on CMA Part 2, each progressively stricter about what counts as a usable resource.

• Current ratio = current assets / current liabilities. The broadest test of short-term coverage.
• Quick (acid-test) ratio = (current assets - inventory - prepaid expenses) / current liabilities. Removes the least liquid current assets, since inventory must first be sold and collected before it becomes cash.
• Cash ratio = (cash + marketable securities) / current liabilities. The most conservative measure, counting only assets that are already cash or near-cash.

Net working capital = current assets - current liabilities. Note this is a dollar figure, not a ratio. A positive value means current resources exceed current claims; lenders often require a firm to maintain a minimum working-capital level as a loan covenant.

Worked Example: Liquidity

Assume: cash $40, marketable securities $20, accounts receivable $90, inventory $120, prepaid expenses $10 (current assets total $280); current liabilities $140.

A current ratio of 2.0x looks healthy, but the quick ratio of 1.07x reveals that inventory drives much of that cushion. If inventory is slow-moving, the firm is less liquid than the current ratio implies. The cash ratio of 0.43x shows only 43 cents of immediate cash per dollar of near-term debt.

Trap: A very high current ratio is not automatically good. It can signal excess inventory, uncollected receivables, or idle cash that should be invested or returned to owners.

Leverage (Solvency) Ratios: Long-Term Survival

Leverage ratios measure how much debt finances the firm and whether earnings comfortably cover fixed financing charges. They assess solvency, the ability to meet long-term obligations as they come due.

Capital-structure ratios describe how the firm is funded:

• Debt-to-equity = total debt / total equity. Higher means more reliance on creditors relative to owners.
• Debt-to-total-assets = total debt / total assets. The fraction of assets funded by debt.
• Financial leverage (equity multiplier) = total assets / total equity. Higher amplifies both gains and losses to owners.

Coverage ratios describe whether earnings or cash can service those obligations:

• Times-interest-earned (TIE) = EBIT / interest expense. EBIT (earnings before interest and taxes) is used because interest is paid from pre-tax, pre-interest profit.
• Fixed-charge coverage = (EBIT + lease payments) / (interest expense + lease payments). Captures lease obligations TIE ignores.
• Cash-flow-to-debt = operating cash flow / total debt. Uses actual cash generated, not accrual earnings, and is a strong predictor of repayment ability.

Worked Example: Leverage

Assume: total debt $600, total equity $400, total assets $1,000; EBIT $180, interest expense $60, annual lease payments $40, operating cash flow $150.

A TIE of 3.0x means EBIT covers interest three times over. A reading below roughly 1.5x signals that a profit dip could leave interest unpaid, a key default warning. Fixed-charge coverage of 2.2x is lower than TIE because it adds lease obligations to the burden, giving a more complete picture for a lease-heavy firm.

Key contrast: TIE uses accrual EBIT; cash-flow-to-debt uses cash generated by operations. A firm can show strong TIE yet weak cash-flow-to-debt if earnings are not converting to cash, a red flag for repayment ability.

Interpreting and Benchmarking

No ratio has a universal "good" value; meaning comes from comparison. Evaluate every liquidity and leverage ratio three ways:

• Trend: Is the firm's own ratio improving or deteriorating over several periods?
• Industry: How does it compare to direct competitors and industry medians?
• Covenants: Does it satisfy the thresholds lenders impose (e.g., minimum current ratio of 1.5x, maximum debt-to-equity of 2.0x)?

What Each Ratio Signals

Leverage cuts both ways. Moderate debt lifts return on equity through the tax shield on interest, but excess debt raises the cost of both debt and equity as distress risk climbs. The CMA exam frequently pairs a leverage ratio with a profitability ratio to test whether you can explain that trade-off.