When evaluating a company's health, financial analysts want to know if the company has access to enough cash to meet its financial obligations. Analysts measure this access using liquidity ratios. Analysts also want to know how the company positioned itself when it acquired its capital, the money used to purchase assets and run the business. The company measures capital using capital structure ratios.
Capital Structure Ratios
Capital structure ratios compare a company's debt and its equity. Debt and equity are the two methods companies acquire capital. Debt refers to money borrowed, while equity refers to money invested or earned. Financial ratios that measure capital structure include the debt-to-equity ratio or the ratio of fixed assets to long-term liabilities.The debt-to-equity ratio divides the total liabilities of the company by the total stockholder equity. The higher the ratio, the more debt the company carries. A debt-to-equity ratio close to one demonstrates a balance between debt and equity. The fixed assets to long-term liabilities ratio divides total fixed assets by the total of all money owed with a repayment date longer than one year. This ratio illustrates the percentage of equity the company has in its fixed assets. Any ratio with a value higher than one demonstrates positive equity in the assets.
Liquidity ratios analyze the company’s ability to access cash when needed. When a company lacks sufficient access to cash, it loses the opportunity to pursue investments and may fall behind in its bills. Liquidity ratios include the current ratio and the inventory turnover ratio. The current ratio compares the current assets, or assets convertible to cash within a year, to the current liabilities, or the debt due within one year. Any value above one demonstrates that the company can pay its current obligations with cash. The inventory turnover ratio determines how many times the company sells out its inventory during the year. The higher the ratio, the more cash the company receives in exchange for the inventory.
Several similarities exist between capital structure ratios and liquidity ratios. Higher values in both capital structure ratios and liquidity ratios communicate a stronger financial position of the company. Also, consistent ratio values demonstrate stability in both capital structure and liquidity ratios.
Capital structure ratios and liquidity ratios focus on different aspects of a business. Capital structure ratios measure how much debt the company has and compares that to the amount of equity. Liquidity ratios evaluate the company’s cash level, allowing the analyst to help predict whether the company may face financial problems. The analyst determines the industry standard for each ratio by calculating the ratio for several companies within that industry. If the company’s ratio varies significantly from the standard, the analyst takes a more detailed look at the company’s financial position.