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Liquidity Ratio – Quick Ratio, Interest Coverage, Debt / Equity Implication for Investors and Marketers

Louis Lu

The liquidity ratio reflects a company’s resilience capability when facing economic and market vulnerability and volatility. As an investor, companies with great liquidity capability definitely are the better options in the investment portfolio. Meanwhile, marketers have a responsibility to adjust budgets and strategies along with business liquidity ratio upsizing or downsizing. Moreover, be sure to constantly communicate with the market and build brand credibility and trustworthiness always-on.

In this article, there are 3 aspects to look into and justify whether a company is in a healthy liquidity ratio status, which includes quick ratio, interest coverage, and debt to equity.

Table of Contents on Liquidity Ratio

Why liquidity ratio matters for investors and marketers

Liquidity ratios in a number of ways are used to gauge what kind of financial shape a company is in. There are three main aspects for investors and marketers necessarily to look into:

To look into whether a company can keep its head above water financially

Many companies can afford all their bills, however, it’s important to investigate what happened if the business might suffer a hiccup suddenly. In this case, the current ratio, quick ratio, and cash ratio are 3 key signal options to generally find out the business resistance.

To see how much borrowing takes from profits

Many companies leverage financing to speed up business development and scale up growth. Nonetheless, the question is whether the business is able to justify that level of borrowing or leverage. As investors and marketers, we need to know how much larger a company’s profit is than interest payments. In this case, the ratio we are able to look into is interest coverage.

To size up how much of a company’s financial resources are tied up in debt

Companies raise funds in a variety of ways, which offering equity and selling debt. However, compared to equity, liability level due to tieing up in debt can damage a company’s liquidity and destroy the company’s, or even cause insolvency and fall into default consequently. In terms of fundraising ways, looking into the ratio between debt and equity or D/E for understanding the company’s health is critical.

Current Ratio, Quick Ratio, Cash Ratio

Knowing how to stress-test a company and knowing what would result if the unexpected happened is what these three ratio metrics do. From left to right in this subject, which are current ratio, quick ratio and cash ratio, basically they are from simplest to the strictest method to quickly evaluate the company liquidity and resilience when facing market vulnerability. Notably it’s for current liability stress testing.

Below is a list of the most common current liabilities that are found on the balance sheet:

Current Ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.

Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense that current assets is the numerator, and current liabilities is the denominator.

However, the quick ratio only considers certain current assets. It considers more liquid assets such as cash, accounts receivables, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.

Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.

Implications for Investors and Marketers

For investors, the liquidity ratio tells a company’s resilience within a year so it implies the company’s short term stock price performance. Notably those companies with worse liquidity ratio easily are impacted by the monetary policy affecting the cost of debt and macroeconomic vulnerability. 

For marketers, when thinking of the marketing strategy, leveraging deferred revenue to launch the prepaid program might be necessarily considered regarding the side effects on the liquidity ratio. It’s because customers might refund and cause the current liability increasing in a short term

Interest Coverage

The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a company can pay the interest on its outstanding debts. The interest coverage ratio is also called the “times interest earned” ratio. Here is the equation as follows:

ICR = EBIT (Earnings Before Interest and Tax) / Interest Expense

or

ICR = EBITDA / Interest Expense

Implications for Investors and Marketers

For investors, on the whole, a higher interest coverage ratio is interpreted as a more healthy finance status because operational profit can pay off interest amount from debt. In the contrast, you need to be careful because the company might be vulnerable or even likely to go bankrupt, it’s not kidding! Basically, it’s insolvent in terms of profit and interest. Lower interest coverage also implies net income might be downsizing and straightforwardly influence the ROE, and ROA performance.

For marketers, there are two things as a marketer that can dedicate to prettify this figure. One is definitely to boost sales and increase operating profit. The other is to keep a stable and credible company image in the market, which helps dilute the sensitivity of a lower interest coverage ratio in a period of time, which can decrease confidence from investors and influence fundraising.

Debt / Equity

The Debt to Equity ratio or called the debt-equity ratio, risk ratio, or gearing, is a leverage ratio that calculates the weight of total debt and financial liabilities against total shareholders’ equity. This ratio highlights how a company’s capital structure is tilted either toward debt or equity financing. Here is the equation follows:

D/E = (Short term debt + long term debt + other fixed payments) / Total shareholder’s equity

On the whole, not all the current liability and non-current liability are counted as total debt. Basically here are the way to categorize as follows:

Items counted into debt

Not considered as debt in D/E calculation:

Implications for investors and marketers:

For investors, except for the difference between industries, basically higher D/E implies the company has better credibility to leverage debt to raise funds for business growth and increase the return on equity (ROE). That’s good. However, please be sure to look into the cost of debt and cost of equity, compared to WACC. It’s because chances are that a higher cost of debt might destroy the company’s value and increase the vulnerability and volatility when facing uncertainties. This needs to be careful.\

To marketers:

On the whole, it’s critical to keep in mind higher D/E can also have an impression of unstable cash flow due to debt repayment and interest coverage, and lower resistance capability when facing economic downsizing. Thus, implementing a marketing communication strategy to deliver a healthy and stable image of a brand to the market is the marketer’s key task. 

Moreover, some items are not counted in the calculation of debt, such as deferred revenues. Marketers can play around with these factors and leverage some tricks to create marketing campaigns to make noise and engage with target audiences, like cashback of 100% after paying in advance within a period of time. 

Easy2Digital Financial Data API

Basically, the liquidity ratio is super helpful to justify whether a company is bleeding faster or slower than gaining the blood. It means quite a lot to investors and marketers for the purpose to meet their task goals.

For any tickers or symbol you like to fetch dataset over the years to analyze the liquidity multiples, please visit Easy2Digital API section and subscribe to Easy2Digital newsletter by leaving a message “API number + free trial”. We will send you asap.

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