Solvency & Liquidity
A profitable company can still go bankrupt if it runs out of cash. Understanding the balance sheet health of a company is non-negotiable before investing.
Liquidity - Can It Pay Its Short-Term Bills?
Current Ratio **Current Ratio = Current Assets ÷ Current Liabilities**
Measures ability to cover short-term obligations. - > 2.0 → comfortable - 1.0-2.0 → adequate - < 1.0 → potential liquidity stress
Quick Ratio (Acid Test) **Quick Ratio = (Cash + Receivables) ÷ Current Liabilities**
Strips out inventory (which may not be quickly convertible to cash). More conservative than the current ratio.
Solvency - Can It Survive Long-Term?
Debt-to-Equity (D/E) **D/E = Total Debt ÷ Shareholder Equity**
- •D/E < 0.5 → conservative (good)
- •D/E 0.5-1.0 → moderate
- •D/E > 1.5 → high leverage - scrutinise the business model
Context matters: Banks and NBFCs operate with high D/E by design. Compare within the same sector.
Interest Coverage Ratio **ICR = EBIT ÷ Interest Expense**
How many times can the company pay its interest from operating profit? - ICR > 5 → strong - ICR 2-5 → adequate - ICR < 2 → danger zone - a small earnings drop could cause default
Debt-to-EBITDA Used by credit analysts and bond markets. - < 2x → low leverage - 2-4x → moderate - > 5x → high - watch carefully
Working Capital Management
Working Capital = Current Assets − Current Liabilities
Cash Conversion Cycle (CCC) = Days Inventory + Days Receivables − Days Payable
A lower (or negative) CCC means the company collects cash from customers before it has to pay suppliers - a sign of strong bargaining power (e.g., supermarkets, D-Mart).
Red Flags to Watch
- •Rapidly rising receivables relative to revenue → customers aren't paying; revenue may be fictitious
- •Promoter pledging > 50% of their shares → they've borrowed against equity; distress signal
- •Debt growing faster than revenue → not being used productively
Key Takeaways
- •Liquidity is about surviving the next 12 months; solvency is about surviving the next decade
- •Always check the interest coverage ratio alongside the D/E ratio
- •Rising debt with falling margins is the most dangerous combination in fundamental analysis