Lesson Objective: To construct a comprehensive “ratios dashboard” that provides a 360-degree view of a company’s financial health, focusing on short-term survival (liquidity), long-term stability (solvency), and operational efficiency (activity).

In-Depth Notes:

1. Liquidity Ratios (Short-Term Survival):
Liquidity ratios measure the company’s ability to meet its short-term obligations (current liabilities) with its short-term assets. This is a primary concern for European banks when setting credit limits.

• Current Ratio = Current Assets / Current Liabilities: A ratio above 1.0 indicates the company has more current assets than current liabilities. However, a ratio above 3.0 may suggest the company is holding excessive cash or inventory, which is inefficient. Under IFRS, if the company has an overdraft facility, that is often netted against cash, which can artificially lower the current ratio; this must be normalized for a true analysis.

• Quick Ratio (Acid-Test) = (Cash + Marketable Securities + AR) / Current Liabilities: This removes inventory, which is the least liquid current asset. A quick ratio below 1.0 is a global warning sign that the company may struggle to pay bills without selling inventory or raising external capital. In Europe, regulators often require a “stress-tested quick ratio” that assumes a 20% write-down on AR to account for potential payment delays during economic downturns.

• Cash Ratio = Cash & Equivalents / Current Liabilities: The most conservative liquidity measure. A cash ratio below 0.3 is typical for most operating companies, but for financial institutions under European CRR, the cash ratio is heavily scrutinized as part of the Liquidity Coverage Ratio (LCR).

2. Solvency and Leverage Ratios (Long-Term Stability):
Solvency ratios assess the company’s capital structure and its ability to meet long-term obligations, including debt repayments.

• Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity: A high ratio indicates high financial leverage. US companies often tolerate higher leverage (3.0x-4.0x) due to the tax shield benefits of interest. European companies, governed by the UK Corporate Governance Code and German “Eigenkapital” (equity) standards, typically maintain lower leverage (1.5x-2.5x) to preserve financial resilience.

• Debt-to-Assets Ratio = Total Liabilities / Total Assets: This shows the percentage of assets financed by debt. The global threshold for a “safe” ratio is generally below 0.6.

• Interest Coverage Ratio = EBIT / Interest Expense: This measures the company’s ability to pay interest on its outstanding debt. A ratio below 1.5x is considered a high default risk by rating agencies like Moody’s and S&P. Under European covenants, a minimum Interest Coverage Ratio is a standard loan condition (covenant).

• Debt-to-EBITDA Ratio (Credit Standard): Total Debt (including the principal portion of leases) divided by EBITDA. This is the most watched metric by credit analysts globally. A ratio below 3.0x is considered “investment grade,” whereas above 5.0x is “high yield” (junk). Under Basel III, European banks must provision more capital for loans where this ratio exceeds 4.0x.

3. Activity and Efficiency Ratios (Operational Speed):
These ratios measure how efficiently a company manages its assets and liabilities to generate cash.

• Inventory Turnover Ratio = COGS / Average Inventory: This indicates how many times a company sells and replaces its inventory in a period. A low turnover suggests overstocking or obsolescence. Under IAS 2, slow-moving inventory must be written down, impacting the P&L.

• Days Inventory Outstanding (DIO) = 365 / Inventory Turnover: The average number of days it takes to sell inventory. A DIO of 60 days means inventory sits on the shelf for two months. For perishable goods (e.g., groceries), DIO must be under 10 days; for heavy machinery, it can exceed 200 days.

• Days Sales Outstanding (DSO) = (Average AR / Net Revenue) * 365: The average days it takes to collect payment from customers. A DSO of 45 days is a global standard. If DSO spikes, it indicates the company’s collection department is failing, or the company is offering extended payment terms to attract customers, which is a cash flow risk.

• Days Payable Outstanding (DPO) = (Average AP / COGS) * 365: The average days it takes to pay suppliers. A longer DPO is beneficial for cash flow (as the company holds onto cash longer), but excessive DPO (e.g., >90 days) may indicate financial distress or strained supplier relationships.

• Cash Conversion Cycle (CCC) = DIO + DSO – DPO: This is the master efficiency metric. A negative CCC (e.g., Amazon) means the company collects cash from customers before it pays its suppliers, representing a free source of financing. A positive, rising CCC is a red flag, indicating the company needs external funding to support its working capital needs.