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Classification of ratios Ratios can be broadly classified into 5 groups namely:
1. Liquidity ratios
2. Leverage ratios
3. Turnover ratios
4. Profitability ratios
5. Valuation ratios
Leverage ratioLeverage ratios measure how leveraged a company is.
Highly leveraged means that the company has taken on too many loans and is in too much debt.
These ratios indicate the long term solvency of a firm and indicate its ability of the firm to meet its long term commitment to:
1) Repayment of amount on maturity or in predetermined instalments at due dates and
2) Paying off loans with interest
Also a riskier source of finance
1) Companies that are too highly leveraged (that have large amounts of
debt as compared to equity) often find it difficult to grow because of
the high cost of servicing the debt
2) A change in interest rates can have an effect on one’s profit too
Leverage Ratios
1) Debt- equity ratio
2) Interest coverage ratio
3) Debt service coverage ratio
4) Debt ratio
Debt- equity ratio1. The Debt-to-Equity ratio (D/E) indicates the proportion of
the company’s assets that are being financed through debt.
2. This ratio tells us how much loan and equity was used to purchase assets
Terms and Conditions!!!If a lot of debt is used to finance increased operations, the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.
Debt- equity ratio= 149,950/171900 = 0.87
Analysis
1) Advantage of a very low Debt equity ratio
2) Paul’s Guitar Shop in progress
3) Capital-intensive industries tend to have higher debt-to-equity ratios than low-capital industries because capital-intensive industries must purchase more property, plants and equipment to operate
Debt- equity ratio=397,785/216159 =1.84
Analysis
1) The company has made equal use of debt and equity
2) Good for the company
3) Company in progress
Debt ratioCompany’s Ability to payoff the loans.
formulas:Debt Ratio:- Total Assets
Total Liabilities
OR
Debt Ratio:- Total Debts
Total Assets
Advantages1) Financial Condition
2) Work Efficiently
3) Future Investment
Disadvantages1) Investors/Lenders
2) Bank Loan
3) High Interest Rate
Interest coverage ratio
Uses: 1) Interest coverage ratio is also known as Times Interest Earned
2) ICR is a measure of company's ability to meets its interest payment; It determines how easily a company can pay interest expenses on outstanding debts
3) It is used to measure company's ability to make its interest payment on its debt in timely manner
Coca cola ICR= profit before interest and taxes/ Interest
ICR= 8.9/2.1
ICR=4.23
The final answer is 4.23 which indicates that the firm is doing really great.
Sarah’s Jam Company Let’s take a look at an interest coverage ratio example. Sarah’s Jam Company is a jelly and jam jarring business that cans preservatives and ships them across the country. Sarah wants to expand her operations, but she doesn’t have the funds to purchase the canning machines she needs. Thus, she goes to several banks with her financial statements to try to get the funding she wants. Sarah’s earnings before interest and taxes is $50,000 and her interest and taxes are $15,000. The bank would compute Sarah’s interest coverage ratio like this
Formula ICR= Profit before interest and taxes/ Interest
ICR= $50,000/$15,000
As you can see, Sarah has a ratio of 3.33. This means that has makes 3.33 times more earnings than her current interest payments. She can well afford to pay the interest on her current debt along with its principle payments. This is a good sign because it shows her company risk is low and her operations are producing enough cash to pay her bills.
Debt Service Coverage Ratio
Ratio of cash a business has available for servicing its debtsAllows lenders to know whether or not a business can repay its potential loanCalculated by comparing its net earnings with the amount of its loans & interest payments.
Importance
A financial scale a lender uses to determine whether or not the business produces enough cash flowsIn business, unexpected expenses can arise. Lenders make sure you have extra padding in your bank account. Example: machinery break down.
Debt service coverage
ratioFormula
DSCR= Net operating income
Total debt service cost
AnalysisWhen net income = the cost of carrying loans it means your DSCR is 1 It tells you that your business is making just enough money to cover 100% of its current debts, without having a dip into its savings, sell of assets Or borrowing more moneyany ratio value at 1 or just above should be viewed with cautionA slightest reduction in earnings could cause a business to become financially overextended
When a company’s debt service coverage ratio is below 1, it’s best regarded as an all-out sign of looming financial difficulty.The debt service coverage ratio measures a company’s ability to sustain its current level of debt. The higher the ratio value is, the better its debt servicing position.A higher coverage ratio indicates a more positive cash flow & it also means a business is more likely to pay down its debts in a timely fashion, since more of its profits from income are available to put toward loan payments.
These ratios measure the debt obligations for a company or a firm
Thank you
