[MUSIC] In this video, we will define what solvency and liquidity ratios are and look at some 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 its interest and principle obligations on long term debt as well as obligations on long term leases. The first solvency ratio is the debt to equity ratio. This measures how much long term debt a company has for each dollar of shareholders' equity capital raised. It is defined as the ratio of the sum of long-term debt and long-term capital leases divided by total shareholders' equity, all of which come from the balance sheet. Amazon's long-term debt in 2015 was $8.24 bilion and its capital leases were $5.95 bilion. It's total shareholders' equity was $13.38 billion. This gives us a debt to equity ratio to be 1.06 in 2015. That is for every dollar raised through equity capital, Amazon raised $1.06 in long term obligation. 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 be that Amazon didn't have as much debt as its competitors in the past but has finally caught up. Another measure that captures how much debt capital a company has is the total liabilities to total assets ratio. This is defined as the company's total liabilities divided by its total assets. Higher this ratio, 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 in assets that Amazon purchases $0.90 come from various forms of liability. Only $0.20 comes from equity capital. This ratio has been fairly stable over the last four years. Given that debt to equity has risen over the same time, it's likely that Amazon has substituted short-term obligations with longer term obligations. One other solvency ratio is the interest coverage ratio which is 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 earnings before interest and taxes EBIT divided by interest expense. EBIT is the profit a company is left 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 its interest expense was $0.46 billion. The interest coverage ratio works out to 4.86, that is EBIT is 4.86 times its interest expense. The rule of thumb is that an interest coverage ratio of greater that 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 ratios, they measure a company's ability to meet its short term obligations. One liquidity ratio is a current ratio. It measures whether a company's current assets are sufficient to meet its current liabilities. It is defined as the ratio of current assets to current liabilities. In 2015, Amazon had current assets worth $36.47 billion and current liabilities worth $33.90 billion which gives us a current ratio of 1.08. For every $1 in current liabilities, Amazon has $1.08 in current assets, the higher this ratio, the better liquidity a company has. A current ratio of two or more is healthy and anything lower may be 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 payoff any of these obligations. It may also be extremely difficult to convert inventory held to cash at 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 while calculating these liquidity ratios. The quick ratio makes this adjustment. It ignores inventory as a current asset and is defined as current asset minus inventory divided by current liabilities. In 2015 Amazon inventory was 10.24 billion dollars. It's current assets and current liabilities were 36.47 billion and 33.90 billion dollars, respectively. Subtracting 10.24 billion from 36.47 billion and then dividing by 33.90 billion dollars gives us a quick ratio of 0.77. For every one dollar in current liabilities, Amazon has 77 cents in current assets, excluding new entry. Amazon's quick ratio, has been fairly stable, over the last four years. A concern with the quick ratio is that accounts receivable is also not truly liquid because a company's ability to convert receivables to cash, depends on when it's customers or clients pay. The cash ratio fixes this problem by ignoring all 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 bilion and current liabilities worth $33.90 bilion in 2015. Dividing the two Amazon's cash ratio comes to 0.58. That is for every $1 in short term obligations due Amazon has $0.58 cents in cash and cash equivalence. The cash ratio has held stable over the last few years and so it doesn't seem to be of concern. This concludes all the financial statements-based ratios. Next time, we will look at the two-point identity which will help us identify why a company's is too high or too low. It helps us identify where is the company doing well and where is it doing poorly. We will also look at one market price based financial ratio. [MUSIC]
