The Quick and Current Ratios at the top of the table are the most stringent tests of financial strength. They measure the level of liquidity that is or could become available to the company in short period of time. The Quick Ratio compares a company's cash and short-term investments (that is, investments that could be converted to cash very quickly) to the financial liabilities the company is expected to incur within a year's time. A ratio of .80 would mean that cash and cash equivalents now available would cover eighty percent of expected year-ahead liabilities. The shortfall below 100% might seem alarming at first glance. But remember, the Quick Ratio is a very stringent test that compares a year's worth of obligations with cash that, for all practical purposes, is already in the bank. Another test, the Current Ratio, compares year-ahead liabilities to cash on hand now plus other inflows the company is likely to realize over that same twelve-month period. These additional expected inflows include such items as Accounts Receivable (payments the company expects to receive within a year from customers who already purchased goods or services) and Inventories (goods the company expects to sell within a year). The Current Ratio is often above 1.00 (100%).

The LT Debt/Equity Ratio looks at the company's capital base. If the ratio is at 1.00, that means the company's long-term debt and equity are equal. Put another way, fifty percent of the company's capital consists of equity (contributed by shareholder-owners) and the other fifty percent was contributed by long-term creditors.

Traditionally, one would analyze a company's leverage on the basis of its long-term debt, which includes debt that is due more than one year hence. Long-Term Debt is assumed to be a "permanent" part of the company's capital structure. Short-term debt is traditionally regarded as not being part of the capital structure. An example of this would be trade debt; i.e., a manufacturer borrows money to finance the purchase of raw material, which is converted into finished products and sold to customers. Once the company receives the proceeds of these sales, it immediately repays the money it borrowed in order to finance its raw material purchases. Such debt is not usually regarded as part of the company's capital base.

But nowadays, borrowing arrangements have become much more flexible. For example, many companies use short-term debt as if was, indeed, part of the capital structure. This occurs when companies continually refinance the debt as soon as it comes due. This might be done if a company expects interest rates to fall. Continually refinancing short-term debts at lower-and-lower interest rates is preferable to locking the company into a long-term obligation at an interest rate that will, a year hence, be well above rates that are likely to prevail in the marketplace.

This strategy can be risky. If the company's interest rate forecast proves wrong, it's cost structure will suffer. It may wind up refinancing its short-term debt at a rate that is well above the rate it might have paid had it borrowed long in the first place. Either way, we suggest looking at total debt/equity as an additional measure of financial leverage as well. When doing so, consider two issues:

• The more debt in a company's capital structure, the greater the financial leverage risk. If business turns weak, there are some costs a company can easily reduce to protect its profits and preserve liquidity. But interest on debt is generally not among these variable costs. Interest must be paid even when revenues are falling. Hefty levels of debt (and heavy interest expense burdens) could led to insolvency if revenues or operating profits remain weak for a prolonged period.
  
  
• The larger the Total Debt/Equity Ratio is relative to the Long-Term Debt/Equity Ratio, the more risk the company faces from the prospect of rising interest rates. But remember, some short-term debt is based on a corporate forecast of lower interest rates, while other types of short-term debt represents "trade borrowings" (such as the above raw materials financing example). You cannot always tell for certain what sort of short-term debt your company has. But you can make some reasonable assumptions by using the Market Guide Report to compare your company's debt ratios with those of its industry peers. A company that uses short-term debt much more aggressively than others in its industry is probably doing so because it expects lower interest rates.

It is generally assumed that higher debt ratios signify greater levels of risk. But don't jump too quickly to conclusions. Companies in industries characterized by stable cash flows can safely carry more debt than is the case for company's whose cash flows follow volatile trends. Before you reach your final conclusion, you will need to compare the company's ratios with those of its industry peers. Look, too, at the final part of the Financial Strength Ratio Comparisons Report, which shows Interest Coverage. Companies with high levels of interest coverage are better able to carry more debt.

QUESTION: Since debt increases risk, why should any company ever carry any debt? Wouldn't it be reasonable to simply restrict consideration to debt-free companies?

ANSWER:There are two reasons why you should not narrow your horizons this way. First, as discussed above, some forms of debt, such as trade debt, are necessary to the day-to-day operation of a business. This is especially so in the financial sector, where much depends on the process of borrowing money and re-lending it at higher rates. Second, permanent debt, prudently used, can enhance corporate returns. You can measure the extent to which this is occurring by examining the Management Effectiveness table.