How to Use Liquidity Ratios in Investment Banking
No matter what kind of shape a company is in, investment bankers can usually find a financial product to offer the management. Investment bankers are a particularly creative and innovative bunch. When a company is growing and in need of cash to expand or grow, the investment bankers’ ability to sell securities is very valuable.
But when a company is running into trouble, and needs creative ways to stay afloat, the investment banker is again tapped to help line up investors willing to inject much needed cash into the company.
Investment bankers can use liquidity ratios in a number of ways to gauge what kind of financial shape a company is in or to tailor the products and services pitched to the company. Here are some ways an investment banker might use the liquidity ratios to understand a company's health:
To size up how much of a company's financial resources are tied up in debt: Companies can raise money in a variety of ways, with offering stock and selling debt being among the most common. The financial ratios help investment bankers see how reliant companies are on debt financing versus equity, or stock, financing. Here's where the debt-to-equity ratio comes in handy.
To determine whether a company can keep its head above water financially: Many companies can afford all their bills as long as the business is humming along. But it's important for investment bankers to understand what would happen if the business suffered a hiccup. Would the company's stumble be enough to make it unable to pay its upcoming bills? The quick ratio was designed to handle this question.
To see how much of a bite borrowing takes from profits: A company can turbo-charge its profits by using all sorts of borrowed money. But the question is whether the business is able to justify that level of borrowing or leverage. Additionally, investment bankers need to know how much larger a company's profit is than interest payments, which is measured by the interest coverage ratio.
Deciphering debt to equity
Companies usually have a number of ways to raise money. And choosing between their chief options — issuing debt or stock — can have a profound influence on the company. For instance, companies that load up on debt can give their profit a real jolt when things go well because they're able to invest the money into moneymaking assets.
But debt comes with a cost (interest), and if the cost of borrowing outstrips the returns, the company is actually destroying value.
Investment bankers, too, must understand the mix of a company's financing sources to tailor the products they sell. For instance, if a company is already getting a big portion of its financing from debt, then it may be a tough sell to talk the company into another debt offering.
Calculating a company's debt-to-equity ratio is pretty straightforward. It's simply the company's total liabilities divided by shareholder's equity. Both of these items are readily available from a company's balance sheet.
Interpreting debt-to-equity ratios is a bit of art mixed with a dash of science. The higher the debt-to-equity ratio is, the greater proportion of a company's finances comes from debt.
It's true that the higher the ratio, the more the company relies on debt financing. Some industries are more stable, though, and can comfortably handle more debt than others can. Industries that require large investment in equipment and those with stable cash flow tend to handle higher debt-to-equity ratios than those with less investment required, like software firms. It's important to consider debt-to-equity along with interest coverage.
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Get up to speed with the quick ratio
Quick! Could you pay off your bills if your income suddenly went to zero? It's a harrowing thought, but that's the kind of thinking investment bankers must sometimes apply to companies. Knowing how to stress-test a company and knowing what would result if the unexpected happened is what the quick ratio does.
The higher the quick ratio, the more the company has in liquid assets (assets that can readily been turned into cash) that could be used to pay upcoming bills. The ratio is calculated as follows:
Notice that the quick ratio excludes inventory. While inventory is an asset that can be sold, it often takes time to sell and the amount received can be unpredictable, so it's excluded from the quick ratio.
How to interpret interest coverage
There are several places where more coverage is better, and that certainly goes for Speedo bathing suits. More coverage is also good for companies when it comes to making interest payments.
When companies take on debt, they're assuming liability for the resulting interest and principal payments. These payments aren't negotiable and companies don't have the right to pay them when they feel like it. Interest is due and must be paid or bad things happen, including wiping out the common shareholders if things degenerate enough. The city of Detroit discovered that in mid-2013.
Investment bankers must understand not only how much debt a company has relative to stock, using the debt-to-equity ratio described earlier, but also how onerous the interest payments are with respect to operating earnings. Interest coverage is a catchall term for a number of ratios designed to help investment bankers measure the significance of interest payments.
With investment bankers, a top interest coverage ratio is EBIT/interest expense, which is calculated by dividing a company's earnings before interest and taxes by the interest expense. The higher a company's interest coverage ratio, the more it's able to afford its interest payments.