# Financial Ratios: Liquidity and Solvency

Posted by financial-modelling.net under Finance |

"Cash is king" - that's one lesson a lot of corporations need to learn the hard way. Include these ratios in your financial model so that management can plan ahead.

**Current ratio**

\[\normalsize{\text{Current ratio} = {\text{Current assets} \over \text{Current liabilities}}}\]

The *current ratio* is calculated by dividing the current (or short-term) assets by the current liabilities and is shown as a decimal number. A current ratio of exactly 1 means that all current liabilities could be paid off with all the current assets. Normally, a current ratio between 1 and 2 is considered solid - but this can vary between industries and accounting policies. Should the ratio fall below 1, a liquidity problem is imminent, while a ratio of 2 or greater shows that a company might have too much cash or unutilised inventory.

**Quick ratio**

\[\normalsize{\text{Quick ratio} = {\text{Cash + Current receivables} \over \text{Current liabilities}}}\]

The current ratio's disadvantage is that it includes tangible assets. But not everything can be turned into cash on short notice, or if it can, probably at less than its book value. The *quick ratio* ignores tangible assets: To calculate it, sum the available cash and the current receivables and divide the sum by the current liabilities. A ratio of less than 1 indicates liquidity problems.

**Equity ratio**

\[\normalsize{\text{Equity ratio} = {\text{Equity} \over \text{Total assets}}}\]

The equity ratio, as a percentage, shows how much of a company’s assets are covered by equity. It is simple the equity divided by the total assets. If an equity ratio is good or bad strongly depends on the industry, the size of the firm and the region it is located in. For example, German small and medium-sized enterprises historically tend to have relatively low equity ratios compared to, for example, comparable companies from the USA. For non-financial companies, a value 30-40% looks solid at first sight. But what is more important than the ratio at one point in time is its development over time: The users of your model want to be able to see long-term trends.

**Dynamic debt-equity ratio**

\[\normalsize{\text{Dynamic debt-equity ratio} = {\text{Liabilities} \over \text{Annual cash flow}}}\]

The dynamic debt-equity ratio, as a decimal number, shows how many years a company would theoretically need to pay off all its liabilities, given that the current cash flow would stay at the same level and no additional liabilities would be incurred. It is calculated by dividing the liabilities by the annual cash flow. The result is the number of years; the lower, the better. If the ratio is calculated as a percentage, 100% represent one year.

[...] Interest cover, equity ratio, the loan life coverage ratio (LLCR), the project life coverage ratio (PLCR) or other liquidity and solvency ratios [...]