3.1Debt Ratio and Current Ratio
As we saw from the financial statements of Walmart, you can get a lot of information just by doing a simple thing: Divide one accounting number by another. The results of these calculations are called financial ratios. Of course, there are hundreds of possible financial ratios, but here we will discuss just six key financial ratios. We will learn the debt ratio, the current ratio, return on sales, asset turnover, return on equity, and price-earnings ratio.
Debt ratio is computed as total liabilities divided by total assets. Debt ratio is a measure of a company’s leverage. Leverage is a common way to describe the degree to which a company has borrowed the money needed to buy its assets, compared to getting that money as investment from owners.
For Walmart, for example, as of January 31, 2018, the $124 billion of total liabilities relative to its $204 billion in total assets means the company borrowed about 60 percent of all of the money it needed to buy its assets. Now, where did Walmart get the other 40 percent? That 40% was invested by shareholders. Walmart’s debt ratio of 60% tells you the extent to which Walmart has financed its business through borrowing.
By comparison, Target has borrowed 70 percent of all of the money it needed to buy its assets. A rule of thumb for large companies around the world is that debt ratio is usually between 50 and 60 percent, so we see that Target has a bit more leverage than average. If leverage gets too high, lenders become nervous about the borrower’s ability to repay its loans. Debt ratio, total liabilities divided by total assets, is a measure of leverage.
A second widely-used ratio is the current ratio. Current ratio is a measure of a company’s liquidity which means the ability of the company to pay its obligations in the short term. Current ratio is computed as current assets divided by current liabilities.
I think we should pause here to learn what a current asset is and what a current liability is. A current asset is an asset that you expect to use within the coming year. Cash, for example, is a current asset. Specific dollars are not going to sit there for a year; you are going to use them, circulate them, and replace them. Inventory is also a current asset. Hopefully you are going to sell and then replace specific items of inventory within the coming year.
Current liabilities are obligations that you expect to pay within the coming year. For example, you expect to pay your suppliers within 30 or 40 days, so accounts payable is a current liability. You expect to pay your employees soon, so wages payable is a current liability.
Current ratio for Walmart here is 0.76, $60 billion of current assets divided by $79 billion of current liabilities. Now, let’s stop for a second, because that 0.76 should make you a little nervous. I’m going to explain to you in just a minute that we don’t need to be worried about Walmart, but let’s be nervous for just a moment, because Walmart doesn’t have enough current assets to be able to pay all of its current liabilities today. Scary. But, of course, Walmart doesn’t actually have to stop today and pay all of its current liabilities with its existing current assets.
How does Walmart pay its obligations on an ongoing basis? With the cash flow that comes in every day. Walmart has a current ratio that is less than one, but that is not a concern because of Walmart’s stable and reliable operating cash flow. Historically, banks like to see less stable companies have current ratios of two or higher. That means if you had to pay all of your current liabilities today with your current assets, you’d have a cushion of more than two to one. Current ratio is a measure of a company’s liquidity, its ability to pay its obligations in the short term.