Liquidity, Solvency and Capital Structure

Liquidity (The Short Term) (Liquidity vs. Solvency - Understanding the Time Horizon)

Focuses on a company’s ability to meet immediate, “due now” obligations using its most liquid assets

Solvency (The Long Term) (Liquidity vs. Solvency - Understanding the Time Horizon)

Focuses on the ability to sustain operations indefinitely and repay long-term debt and interest

The Difference (Liquidity vs. Solvency - Understanding the Time Horizon)

A company can be solvent (high value in land / buildings) but illiquid (no cash to pay this week’s wages). Conversely, a liquid company can be insolvent if its total liabilities exceed its total assets.

Current Ratio (CR) (Primary Liquidity Ratios - Measuring the Safety Net)

Current Assets / Current Liabilities, measures if the company has at least $1.00 in assets for every $1.00 of debt due this year

Quick Ratio (The Acid Test) (Primary Liquidity Ratios - Measuring the Safety Net)

(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities, a more conservative test that removes inventory, which may be slow to sell or obsolete

Cash Ratio (Primary Liquidity Ratios - Measuring the Safety Net)

(Cash + Marketable Securities) / Current Liabilities, the “worst-case scenario” metric - can we pay bills if sales stop tomorrow

Working Capital Formula (Working Capital - The Operational Cushion)

Current Assets - Current Liabilities

Positive Working Capital (Working Capital - The Operational Cushion)

Indicates the company can fund its own growth and meet obligations without external obligations

Negative Working Capital (Working Capital - The Operational Cushion)

This can be a red flag for bankruptcy or a sign of extreme efficiency, e.g. companies like McDonald’s or Dell that collect cash from customers before paying suppliers

Debt-to-Equity (D/E) (Solvency & Leverage Ratios - The Debt Load)

Total Debt / Shareholder’s Equity, indicates how much the company is leveraged, high D/E suggests aggressive growth funded by lenders

Debt-to-Capital (Solvency & Leverage Ratios - The Debt Load)

Total Debt / (Total Debt + Equity), measures debt as a percentage of the total “funding pie”

Interest Coverage (Solvency & Leverage Ratios - The Debt Load)

EBIT / Interest Expense, measures how many times a company can pay its interest with its operating profit, a ratio below 1.5x is usually a major warning sign

Equity Financing (Capital Structure - The Financing Mix)

Raising money from owners

Equity Financing pros and cons (Capital Structure - The Financing Mix)

Pros: no repayment required, no interest; Cons: Dilution of ownership, dividends are not tax-deductible

Debt Financing (Capital Structure - The Financing Mix)

Borrowing from banks / bondholders

Debt Financing pros and cons (Capital Structure - The Financing Mix)

Pros: interest is tax-deductible, no loss of control; Cons: Mandatory interest / principal payments regardless of profit

Optimal Structure (Capital Structure - The Financing Mix)

The goal is to reach the “Lowest WACC” (Weighted Average Cost of Capital)

Operational Risk (Financial Risk vs. Operational Risk)

Risk that is inherent in the business model (e.g. a restaurant failing because the food is bad)

Financial Risk (Financial Risk vs. Operational Risk)

Risk that is added by the capital structure, even a good business can fail if it takes on too much debt and cannot meet interest payments

Bankruptcy Risk (Financial Risk vs. Operational Risk)

When the interest coverage stays below 1.0 for an extended period, leading to a technical default

Trend Check (Practical Checklist for Analysts)

Is the Quick Ratio declining over the last 4 quarters

Benchmark (Practical Checklist for Analysts)

Is the D/E significantly higher than the industry average

Maturity (Practical Checklist for Analysts)

When does the “long-term debt” actually come due?