Liquidity and Solvency Ratios
Given the continued slowdown of economic activity, we want to focus this month on the use of
liquidity and solvency ratios in managing available cash in your business. We assume that your
enterprise is utilizing financial statements on a regular basis that are accurate. (Please see the
Financial Statement memo available online under Resources for more information.)
Liquidity ratios provide indicators as to the company’s capacity to service debt in the short term
while solvency ratios address the company’s ability to service long-term debt. Banks are
especially interested in liquidity and solvency, showing the ability to pay rather than just the
collateral securitizing the loan.
The current economy has caused sales to slow dramatically and the timeframe to collect
Accounts Receivables to lengthen. Liquidity becomes the point of focus for survival. Unlike
sales, expenses seem to remain steady and while vendors are seeking cash more quickly,
Accounts Payable payments tend to be deferred in order to conserve cash.
Forecasts and budgets are key tools for successfully navigating this downturn. Best and worse
case scenarios should be developed so that the company can prepare for either direction with
confidence that enough cash is available for the continuance of operations. Weekly cash
forecasts that tie to the budget aid in predicting potential cash crunches. Quarterly
budget/forecast reviews allow for anticipation of cash needs and allow for strategies to be
adjusted to reflect the changing environment.
Liquidity Ratios
Working Capital
While there are many ratios that a company can consider in analyzing the financial statements,
one of the most vital is current liquidity.
Working Capital = Current Assets – Current Liabilities
Positive working capital shows sufficient current assets to meet current liabilities. However, the
speed that AR and Inventory becomes cash becomes the next focus in this economy (below).
Negative working capital is a serious warning that the company has current liabilities in excess
of current assets and can easily face a liquidity crisis. Future cash in-flows and payment
scheduling is critical. Today extra working capital is a blessing to be guarded.
Current Ratio
Cathedral Consulting Group, LLC
Page 1
Current ratio is another working capital assessment tool that shows the percentage of coverage
current liabilities have.
Current Ratio = Current Assets / Current Liabilities
If the current ratio is 1.25, then each $1 of current liabilities has $1.25 of current assets to satisfy
it. As noted above, current ratio does not say that cash in-flows will match payments (below).
The next set of ratios is designed to monitor the speed at which current assets become cash. In
an economic downturn this monitoring is critical for anticipating cash for debt payments.
Accounts Receivable Turnover
In order to understand how quickly your company converts Accounts Receivables into cash,
calculate the turnover of AR. This ratio indicates how many times AR turns over completely
within a year. The higher the turnover, the faster the company is converting AR to cash.
Different businesses have differing rates so the trend is what needs to be monitored.
AR Turnover = Sales on Account / Average AR
Accounts Receivable Days Sales Outstanding
This ratio tells us the average length of time a sale on AR takes to turn into cash. Note that this
ratio is sales on AR, not all sales. Many companies accept credit cards, avoiding AR altogether.
While there are credit card fees, the speed of cash flow, avoidance of bad debts, added
convenience to customers, and ease of transactions make it worthwhile.
AR days sales outstanding = AR / Sales on AR
The final AR analysis is Aging AR. AR is broken down into those that are greater than 30 days,
60 days, 90 days, etc. The tracking of aging is most helpful in monitoring slowing payments and
allows customers to be followed up to keep payments timely.
Inventory Turnover
This ratio indicates the number of times that inventory is turned over within a year. A higher
turnover rate indicates that inventory is moving quickly, minimizing the risk of carrying items that
could become obsolete or that incur high carrying costs. Speed in inventory turn is directly
related to cash availability. Monitoring inventory turnover gives an early warning of potential
slowing of cash flows.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Solvency Ratios
Debt Ratio
The Debt Ratio indicates what percentage of the company’s assets is provided through its
creditors. For example, if the debt ratio is 50% that indicates that creditors are providing $.50 on
every dollar of assets at the company.
Debt Ratio = Total Liabilities / Total Assets
Cathedral Consulting Group, LLC
Page 2
Equity Ratio
Like the debt ratio, the equity ratio indicates what percentage of the assets is covered by funds
provided by equity owners.
Equity Ratio = Total Equity / Total Assets
Debt to Equity Ratio
This ratio allows us to determine the solvency of a company. If this ratio is above one it
indicates that the company carries more liabilities than equity.
Debt to Equity Ratio = Total Liabilities / Total Equity
In the current economy financial strength is the key. Therefore less debt and better debt/equity
ratios will be the trend for the future. This is called “deleveraging.”
Tutorials & Articles for Further Reading
 “Beginners Guide to Financial Statements.” This article walks through the basics of
financial statements and ratios. Unlike many sites, this article includes a good overview
of the Cash Flow Statement. http://www.sec.gov/investor/pubs/begfinstmtguide.htm
 Mulit-millionaire Norm Brodsky provides the 10 top lessons he learned over his 30 years
in business, including important lessons on understanding financial statements and
liquidity. http://www.inc.com/magazine/20081001/street-smarts-secrets-of-a-110-millionman.html
 For additional financial ratios and to use American Express’ calculation tool, see
http://www133.americanexpress.com/osbn/tool/ratios/financialratio.asp.
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director in the New
York Office. Sharon Nolt is a former Senior Associate in the New York Office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at info@cathedralconsulting.com.
Cathedral Consulting Group, LLC
Page 3