[MUSIC] In this video we will define what solvency and liquidity ratios are and look at some of the different types of these ratios. We will continue to use Amazon's financial statements from 2015 to calculate these ratios and compare them to Amazon's ratios from prior years. Solvency ratios measure a company's ability to meet it's interest and principle obligations on long term debt. As well as obligations on long term leases. The first solvency ratios is debt to equity ratios. This measures how much long debt a company has for each dollar of the shareholder's equity capital raise. It is defined as the ratio of the sum of long-term debt and long-term capital leases to total shareholders' equity. All of which come from the balance sheet. Amazon's long term debt in 2015 was $8.24 billion and its capital leases were $5.95 billion. Its total shareholders' equity was $13.38 billion, this gives us debt-to-equity ration to be 1.06 in 2015. That is for every $1 raise through equity capital Amazon raised $1.06 in long term obligations. Over the last four years this ratio has more than doubled. So there may be concern that Amazon has too much debt. But we will have to check the debt-to-equity ratios of Amazon's competitors. They may also have similar debt-to-equity ratios and it may just be that Amazon didn't have as much debt as its competitors in the past and has finally caught up. Another measure that captures how much debt or capital a company has is the total liabilities to total assets ration. This is defined as the company's total liabilities divided by it's total assets. Higher this ration more the obligations both short and long term a company has. Also higher this ratio the lower equity capital a company has. In 2015 Amazon had total liabilities of 52.06 billion and total assets of $65.44 billion which gives us a total liabilities to total assets ratio of 0.80. For every $1 and assets that Amazon purchases, 80 cents comes from the various form of liabilities only 20 cents comes from equity capital. This ratio has been fairly stable over the last 4 years. Given that debt-to-equity ratio has risen over the same time, it is likely that Amazon has substituted short-term obligaitons with long term obligations. One other solvency ratio is the interest coverage ratio also called times interest on, this is based on income statement items. It measures if a company has earned enough profits to make its interest payments. It is defined as the EBIT divided interest expense. EBIT is the profit a company's left over with after taking care of all expenses except interest and taxes, interest is paid from EBIT. In 2015, Amazon had an EBIT of $2.23 billion and interest expense of $0.46 billion. The interest coverage ratio works out to be 4.86. That is, its EBIT is 4.86 times its interest expense. The rule of thumb is that an interest coverage ratio of greater than two is good, anything lower than that is of concern. Except 2014, Amazon has maintained a sufficiently high interest coverage ratio. Though it has been on the decline. This could be because Amazon has been taking on more long term obligation which we discussed earlier. Moving on to liquidity issues that measure a company's ability to meet their short term obligations. One liquidity ratio is the current ratio. It measures whether a company's current assets are sufficient to meet its current liabilities. It is defined as the ratio of its current assets to current liabilities. In 2015, Amazon had current assets worth $36.47 billion. And current liabilities were $33.90 billion which gives us a current ratio of 1.08. For every $1 in current liabilities, Amazon had $1.08 in current assets. Higher this ratio, the better liquidity a company has. A current ratio of two or more is healthy and anything lower maybe cause for concern. Amazon's current ratio has been just slightly higher than one the last four years. However that may not be of concern as it has a negative cash conversion cycle, which means that its current assets are converted to cash before its current liabilities become due. While the current ratio tells us how easily a company pays off its current liabilities, inventories cannot be used to pay any of these obligations. It may also be extremely difficult to convert inventory held to cash in short notice. In that sense inventory is not very liquid and so it may not be appropriate to include inventory as a part of current assets when calculating liquidity issues. The quick ration makes this adjustment. It ignores inventory as a current asset and is defined as current asset minus inventory divided by currently liabilities. In 2015, Amazon's inventory was $10.24 billion. Its current assets and current liabilities were $36.47 billion and $33.90 billion respectively. Subtracting $10.24 billion from $36.47 billion and then dividing by $33.90 billion gives us a quick ratio of 0.77. For every $1 in current liabilities, Amazon has 77 cents in current assets excluding inventory. Amazon's quick ratio has been fairly stable over the last four years. But concern with the quick ratio is that accounts receivable is also not truly liquid because a company's ability to convert receivables to cash depend's on when it's customers or clients pay. The cash ratio fixes this problem by ignoring or types of current assets other than cash and cash equivalents. It is defined as cash and cash equivalents divided by current liabilities. Amazon had Cash and Cash Equivalents worth $19.81 billion and current liabilities worth $33.90 billion in 2015. Dividing the two, Amazon's cash ratio comes out to be 0.58. That is why every 1$ in short term obligations due, Amazon has 58 cents in Cash and Cash Equivalents. The cash ratio has held stable over the last few years and so doesn't seem to be of concern. This concludes all the financial statements based ratios. Next time we will look at the DuPont identity which help us identify why a companies ROE is too low or too high. It helps us identify where the company is doing well and where it is doing poorly. You will also look at one market price based financial ratio. [MUSIC]
