Tag Debt ratio

Overview of financial ratios

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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.

 

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Capital structure decisions analysis with debt ratios

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When analyzing capital structure decisions, external stakeholders can obtain an approximate idea of the capital structure of the particular firm by using information in the firm’s financial statements to calculate various debt ratios.

When analyzing capital structure decisions of firms as outsiders, we need to consider two types of debt measures:

The first type of debt ratio measures the degree of indebtedness. This refers to how much debt the firm has relative to other balance sheet’s amounts. The debt ratio will measure the degree of indebtedness.

The second type of debt ratio measures the ability to service debts. This type of debt ratios measures the ability of the business to meet its obligations associated with debt, as they come due. Times Interest Earned Ratio and Fixed Payment Coverage Ratio will be considered to measure the ability to service debts.

Both techniques are very simple to use and effective at analysing capital structure decisions.

Measuring the degree of indebtedness

THE DEBT RATIO

A direct measure of debt is a debt ratio. Debt ratios provide direct information on the financial leverage of an enterprise. Debt ratios measure 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) and the higher the risk. The formula for the debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

Example:

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.

Measuring the ability to service debts

TIME INTEREST EARNED RATIO (INTEREST COVERAGE RATIO)

The Times Interest Earned Ratio (TIER or Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due).

When analyzing capital structure decisions, we can use the Times Interest Earned Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Times Interest Earned Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Times Interest Earned Ratio is as follows:

Times Interest Earned Ratio =EBIT/interest charges

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

EXAMPLE:

Assume ABC Company 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

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

ABC’s Times Interest Earned Ratio 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.

When using the Times Interest Earned Ratio, 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. It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest. The calculation above excludes the principal amount borrowed.

Generally, the higher the Times Interest Earned Ratio the lower the risk an enterprise will not be able to meet its contractual interest obligations on time. Therefore, generally, a higher Times Interest Earned Ratio is the better.

However, cognizance needs to be taken of the fact that the higher the Times Interest Earned Ratio, the lower the risk and lower the return. Therefore, at some point, the Times Interest Earned Ratio may be too high. This will occur if the business is unnecessarily careful with taking up debt as a source of financing, which results in very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

FIXED PAYMENT COVERAGE RATIO

Fixed Payment Coverage Ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. When analyzing capital structure decisions, 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 Fixed Payment Coverage Ratio the higher the degree of financial leverage (amount of debt) 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

EXAMPLE:

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, Fixed Payment Coverage Ratio should be compared to industry average before any conclusions are drawn. Generally, the higher the Fixed Payment Coverage Ratio the lower the risk that enterprise will not be able to meet its fixed-payment obligations on time. Therefore, a higher Fixed Payment Coverage Ratio is the better.

However, as with Times Interest Earned ratio, cognizance needs to be taken of the fact that the higher the Fixed Payment coverage 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 the business is unnecessarily careful with taking up more debt which results in a very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

***

When analyzing capital structure decisions with the help of debt ratios, one should compare debt ratios of individual firms to industry averages. There is a large variability of debt ratios’ industry averages between industries. This is because different industries have different operations requirements. There is no one perfect ratio. Appropriate ratios to use should determined by the company in question, taking into account company’s ‘s strategy, operating environment, competitive environment and finances.

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The debt ratio

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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.