Generally a working capital ratio of 2:1 is regarded as desirable. However the circumstances of every business vary and you should consider how your business operates and set an appropriate benchmark ratio.

A stronger ratio indicates a better ability to meet ongoing and unexpected bills therefore taking the pressure off your cash flow. Being in a liquid position can also have advantages such as being able to negotiate cash discounts with your suppliers.

A weaker ratio may indicate that your business is having greater difficulties meeting its short-term commitments and that additional working capital support is required. Having to pay bills?before payments are received may be the issue in which case an overdraft could assist. Alternatively building up a reserve of cash investments may create a sound working capital buffer.

Ratios should be considered over a period of time (say three years), in order to identify trends in the performance of the business.

The calculation used to obtain the ratio is:  Working Capital Ratio =

    Current Assets       Current Liabilities Acid-Test Ratio

What Does Acid-Test Ratio Mean?A stringent test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets.

Calculated by:

Investopedia explains Acid-Test RatioCompanies with ratios of less than 1 cannot pay their current liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower than the working capital ratio, it means current assets are highly dependent on inventory. Retail stores are examples of this type of business. 

The term comes from the way gold miners would test whether their findings were real gold nuggets. Unlike other metals, gold does not corrode in acid; if the nugget didn't dissolve when submerged in acid, it was said to have passed the acid test. If a company's financial statements pass the figurative acid test, this indicates its financial integrity. What Does Acid-Test Ratio Mean?A stringent test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets.

Calculated by:

Investopedia explains Acid-Test RatioCompanies with ratios of less than 1 cannot pay their current liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower than the working capital ratio, it means current assets are highly dependent on inventory. Retail stores are examples of this type of business. 

The term comes from the way gold miners would test whether their findings were real gold nuggets. Unlike other metals, gold does not corrode in acid; if the nugget didn't dissolve when submerged in acid, it was said to have passed the acid test. If a company's financial statements pass the figurative acid test, this indicates its financial integrity.

Debt/Equity Ratio

What Does Debt/Equity Ratio Mean?A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

 

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as companies'.

Investopedia explains Debt/Equity RatioA high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5. Calculating Debt-to-EquityThe debt-to-equity ratio offers one of the best pictures of a company's leverage. The formula is straightforward:

= Total Liabilities / Total Shareholders' Equity

Quite simply, the higher the figure, the higher the leverage the company employs. Notice that this ratio uses all liabilities (short-term and long-term), and all owner's equity (both invested capital and retained earnings).

Interpreting the RatioLet's say a company has long-term debt of $10 million in the form of a bond outstanding and equity of $10 million. The debt-to-equity ratio is 1 (10/10=1). If the same company has the bond outstanding and only $1 million in equity, then the debt-to-equity ratio is 10 (10/1=10). This company is probably in big trouble. Alternatively, if the company has the $10 million bond outstanding and $20 million in equity, giving a debt-to-equity ratio of 0.5, investors can feel a little bit more comfortable. We can interpret a debt-equity ratio of 0.5 as saying that the company is using $0.50 of liabilities in addition to each $1 of shareholders' equity in the business.

Granted, a company with no debt may be missing an opportunity to increase earnings by financing projects that will give a better return than the cost of the debt. A little debt can be good for a company's earnings. On the other hand, a high debt-to-equity ratio translates into higher risk for shareholders since creditors are always first in line for compensation should the company go bankrupt. Shareholders must wait at the back of the queue for dibs on assets.

In the big picture, the debt-equity ratio tells us that debt isn't bad as long as there is a sufficient amount of equity. When an investor buys equity it reflects positively on the company's outlook. On the other hand, it's a bad situation when a company can only raise money by issuing debt.