Liquidity ratios measure a company’s ability to meet short term obligations. It also indicates how quickly it turns assets into cash.
Liquidity Ratios  
Current ratio  Higher number implies greater liquidity.  
Quick ratio  Higher number implies greater liquidity.
More conservative than current ratio as only more liquid current assets are included. 

Cash ratio  This is the most conservative liquidity ratio, and a good measure of a company’s ability to handle a crisis situation.  
Defensive interval ratio  Measures the number of days a company can operate before it runs out of cash.
Higher number implies greater liquidity. 

Cash conversion cycle (net operating cycle) 
Days of inventory on hand (DOH) + Days of sales outstanding (DSO) – Number of days of payables

The time between cash paid (to suppliers) and cash collected (from customers).
A low number is better for the company as it means high liquidity. Long cash conversion cycle implies low liquidity 
The example below for ABC Corp. illustrates the cash conversion cycle. The timeline for various events is illustrated below:
Solvency ratios measure a company’s ability to meet long term obligations. In simple terms, it provides information on how much debt the company has taken and if it is profitable enough to pay the interest on debt in the long term. It has to be analyzed within an industry’s perspective. Certain industries such as real estate use a higher level of leverage.
Solvency Ratios  Formula  Interpretation 
Debt ratios  
Debt to assets ratio  Measures the amount of debt in total assets.
Higher debt means low solvency and higher risk. A ratio of 0.5 implies 50% of assets are financed with debt. 

Debt to capital ratio  Measures the amount of debt as a percentage of capital (debt + shareholder’s equity).  
Debt to equity ratio  Measures the amount of debt as a percentage of equity.  
Financial leverage ratio  Measures the amount of assets per unit of equity.
Higher value means company is more leveraged. 

Coverage ratios  
Interest coverage ratio (also called ‘times interest earned’  Measures the company’s ability to make interest payments (how many times the company can make interest payments with its EBIT).
Unlike the other solvency ratios, higher value for this ratio is better as it means stronger solvency. 

Fixed charge coverage ratio  Measures the ability of a company to pay interest on debt.
Here, lease payments are added to EBIT as they are an obligation like interest payments. Like interest coverage ratio, higher value for this ratio implies stronger solvency. 
Note that there are two categories of solvency ratios: debt (or leverage) ratios and coverage ratios.
In general, a high debt (or leverage) ratio implies a high level of debt, high risk and low solvency. With coverage ratios, a high number is good because this indicates high income relative to interest payments.
Profitability ratio  Formula  Interpretation 
Return on Sales  
Gross profit margin  Higher value means higher pricing and lower costs.  
Operating profit margin  Operating profit = gross profit – operating costs.
Good sign if operating profit margin grows at a faster rate than gross profit margin. 

Pretax margin  EBT = operating profit – interest related expenses.
Needs further analysis if pretax income increases only because of nonoperating income. 

Net profit margin  Net profit = revenue – all expenses.  
Return on Investment  
Operating ROA  For return, either net income or operating income (EBIT) can be used.  
Return on assets (ROA)  For return, either net income or operating income (EBIT) can be used.  
Return on total capital  Like operating ROA, EBIT is used. Measures return on capital before deducting interest.  
Return on equity (ROE)  A very important measure of return earned on equity capital. Unlike return on common equity, it includes minority and preferred equity.  
Return on common equity  Money available to common shareholders. 
DuPont Analysis: The Decomposition of ROE
DuPont analysis decomposes a firm’s ROE to better analyze a firm’s performance.
Start with ROE
Traditional DuPont equation is
Extended DuPont equation is
Example
The following data is available for a company:
2010  2011  2012  
ROE  19%  20%  22% 
ROA  8.1%  8%  7.9% 
Total asset turnover  2  2  2.1 
Based only on the information above, the most appropriate conclusion is that over the period 2010 to 2012, the company’s:
Solution:
A quick glance at the data says profitability is going up and asset turnover has slightly increased from 2010 to 2012. ROA is going down from the second year.
First, break down ROE into:
ROE is going up (first row). Since ROA is going down, leverage must increase for ROE to increase. So A is incorrect.
Next, to determine if net profit margin increased or decreased, break down ROA into . Since or asset turnover is increasing, net profit margin has to decrease for return on assets to decrease. So, the correct answer is C.