What is a good liquidity ratio

what is a good liquidity ratio

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Doing the Math

When figuring the ratio, add short-term and long-term debt obligations together. Then add intangible and tangible assets together. Divide debt by assets and convert the answer to a percentage. For example, the debt ratio for a business with $10,000,000 in assets and $2,000,000 in liabilities would be 0.2. This means that 20 percent of the company's assets are financed through debt.

What It Indicates

The resulting percentage taken from calculating this ratio shows what portion of the company's assets is financed through borrowing and is used as an indicator of a company's ability to meet those debt obligations. A lower debt-to-asset ratio suggests a stronger financial structure, just as a higher debt-to-asset ratio suggests higher risk.

Risk Analysis

A debt-to-asset ratio above 30 percent indicates risk, according to Adam Kantrovich, a business management educator with Michigan State University. Kantrovich calls a company with a 51 percent or higher debt-to-asset ratio a highly leveraged business. When a business finances its assets and operations

mainly through debt, creditors may deem the business a credit risk and investors shy away. However, one financial ratio by itself does not provide enough information about the company. When considering debt, looking at the company’s cash flow is important. These figures, looked at along with the debt ratio, give a better insight into the company's ability to pay its debts.

Comparisons

A debt-to-asset ratio provides information for one point in time. Therefore, analysts, investors and creditors need to see subsequent figures to assess a company's progress toward reducing debt. In addition, the type of industry in which the company does business affects how debt is used, as debt ratios vary from industry to industry and by specific sectors. For example, the average debt ratio for natural gas utility companies is above 50 percent, while heavy construction companies average 30 percent or less in assets financed through debt. Thus, to determine an optimal debt ratio for a particular company, it is important to set the benchmark by keeping the comparisons among competitors.

Source: ehow.com

Category: Bank

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