Overview of financial ratios

Liquidity ratios

Current ratios measure liquidity, which refers to the ability of the firm to meet its short-term debt obligations. The formula for current ratio is as follows:

Current ratio=Current assets/Current liabilities

A positive current ratio is a must. A current ratio of at least two is generally advisable. If a company has current ratio of two, it means that it has current assets which would be able to cover current liabilities twice.

Activity ratios

Total asset turnover calculates how efficiently assets are used to generate sales. In other words, how efficiently the balance sheet is managed.

Total asset turnover=Sales/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Inventory turnover ratio measures the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory.

Inventory turnover ratio = Cost of goods sold/Inventory

The result of this ratio is only meaningful in comparison. It can be compared to industry averages, to firms past inventory turnover ratios and to inventory turnover ratios of competitors.

Industry averages differ significantly between industries for inventory turnover ratio. Inventory turnover is positive (higher than zero) as long as firm has any inventory. Generally high inventory turnover is considered to be a good indicator.

However, the norm would differ significantly between industries. If industry turnover is too high compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales.

Debt ratios

Debt ratio measures how many of firm’s assets are financed by debt. The formula for debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

For example, assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000. The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Debt-equity ratio measures how much of equity and how much of debt a company uses to finance its assets.

Debt-equity ratio = Total debt / Equity

If the debt-equity ratio is less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that debt is mostly used for financing. If the debt-equity ratio is equal to one, then it means that half of financing comes from debt and half from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher potential return. Financial risk refers to risk of firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due). The formula for the Times Interest Earned Ratiois as follows:

TIER=EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to Income Statement format to see how it is calculated).

For example, assume that ABC has an operating profit of $550,000 and interest charges of $100,000. The TIER of ABC is as follows:

$550,000/$100,000=5.5

One should also compare ratios of individual firms to industry averages, to obtain a better understanding. It is generally advisable that TIER should be between 3 and 5.

ABC’s TIER could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk the firm takes is lower than average, but so is the return.

Profitability ratios

Operating profit margin measures how much of each sales dollar remains after all costs except for interest, tax and preferred dividends are deducted.In other words it measures how efficient the business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

Operating profit margin = Operating profit/Sales

For example, if ABC has a operating profit of $500,000 and sales of $3,000,000 then the operating profit margin is calculated as follows

Operating profit margin = $500,000/$3,000,000

Operating profit margin = 0.167 or 16.7%

The higher the operating profit margin, the better it is.

Return on total assets (ROA) is also called return on investment (ROI). It refers to how effective management is in generating returns on assets of the firm.

ROA/ROI=Earnings available for common stockholders/Total assets

For example, if ABC’s total assets are $3,500,000 and the earnings available for common stockholders is $400,000 than

ROA/ROI=400,000/3,500,000

ROA/ROI=0.11

This means that for every dollar of assets, ABC earned 11 cents. The more the firm earns on every dollar of assets the better.

 

Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:

Times Interest Earned Ratio = EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).

Example


Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The Times Interest Earned Ratio (TIER) of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio (TIER) could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

Things to note about this ratio


When using the Times Interest Earned Ratio (TIER), it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio (TIER). It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.

One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios industry averages between industries. This is because different industries have different operations requirements.

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Fixed Payment Coverage Ratio

The fixed payment coverage ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. In other words, the fixed payment coverage ratio measures the ability to service debts.

As outsiders, when analyzing the capital structure decisions of firms, we can use the fixed payment coverage ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk.

The formula for the fixed payment coverage ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT = earnings before interest and tax (operating profit)

LP = lease payments

I = interest charges

PP = principal payments

PSD = preferred stock dividends

T = tax rate

Test yourself


Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The fixed payment coverage ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The fixed payment coverage ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, the ratio should be compared to the industry average before any conclusions are drawn.

Note the following


Generally, the higher the ratio the lower the risk that  enterprise will not be able to meet its fixed-payment obligations on time. Therefore, generally, a higher ratio is better. However, as with times interest earned ratio, cognizance needs to be taken of the fact that the higher the ratio the lower the risk and lower the return.

Therefore, at some point, the fixed payment coverage ratio may be too high. This will occur if a business is unnecessarily careful with taking up more debt. This will result in very low risk, but also in lower return. This, of course, is not aligned with the overall goal of the enterprise, which is the maximization of the wealth of its shareholders.

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Debt-equity ratio analysis

Debt-equity ratio analysis is one of several debt ratio analyses. Debt ratios measure the degree or financial leverage of the firm. The more debt the firm uses, the higher its financial leverage, the higher its financial risk (the risk of bankruptcy) and the higher the potential returns.

It measures the degree of indebtedness of the enterprise. It measures how much of equity and how much of debt a company uses to finance its assets. It is also referred to as leverage or gearing.

The formula is as follows:

Debt-equity ratio = Total liabilities/Shareholders equity

This formula is sometimes presented simply as:

Debt-equity ratio = Debt/Equity

Example of a debt-equity ratio analysis


Assume Gold Co. currently has total debt of $1,000,000 and shareholders equity of $1,800,000. The debt-equity ratio for the Gold Company is conducted as follows:

$1,000,000/$1,800,000=0.56

The result is less than 1 and indicates that business uses mainly equity to finance its operations. The financial risk of Gold Company seems to be under control. However, it is possible that company may have lower than possible returns due to being too careful with using debt financing. However, a closer investigation is required before any conclusions can be made.

Things to note about this ratio


If the debt-equity ratio shows a result of less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that the debt is mainly used for financing of operations. If the result of debt-equity ratio analysis is equal to one, then it means that a half of financing comes from debt and a half comes from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher the potential return. Financial risk refers to the risk of the firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

The results should be compared to industry averages, to the firm’s past ratio trends and to a similar analysis of leading competitors within the industry.

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The debt ratio

A direct measure of debt of the firm is the debt ratio. Debt ratio measures how many of the firm’s assets are financed by debt. The higher the debt ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk and potential return.

The formula for the debt ratio is as follows:

Debt Ratio = Total liabilities/Total assets

If the debt ratio is higher than 1 than it means that an enterprise has more debt than assets. If the debt ratio is lower than 1 than it means that an enterprise has more assets than debt.

EXAMPLE:

Assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Test yourself


Dillon Corporation has total liabilities of $4,000,000 and total assets of $5,500,000.

Required: Find the debt ratio of Dillon Corporation

Solution:

The ratio is calculated as follows:

$4,000,000/$5,500,000 = 73%

This means that Dillon Corporation’s capital structure is 73% of debt and 27% of equity. A debt ratio of 73% is generally considered to be a very high debt ratio and may indicate a problem of a very high indebtedness and very high financial risk. However, as with all financial ratios, the debt ratio of Dillon Corporation should be compared to the industry average before any conclusions are drawn.