INTRODUCTION The term “ratio analysis” refers to the analysis of the financial financial statements in conjunction with the interpretations of financial results of a particular period of operations, derived with the help of 'ratio'. Ratio analysis is used to determine the financial soundness of a business concern. In this blog post, we will introduce ratio analysis, what it is used for, what are the advantages and disadvantages of it and its limitations.
MEANING AND DEFINITION DEFINITI ON OF RATIO ANALYSIS ANALYSIS Ratio analysis is a conceptual techniue which dates bac! to the inception of accounting, as a concept. "inancial analysis as a scientific tool is used to carry out the calculations in the area of accounting. In order to appraise the valid and e#istent worth of an enterprise, financial tool comes handy, regularly. $esides, it also allows the firms to observe the performance spanning across a long period of time along with the impediments and shortcomings. "inancial analysis is an essential mechanism for a clear interpretation of financial statements. It aids the process of discovering, the e#istence of any cross%sectional and time series lin!ages between various ratios. "ormerly, "ormerly, &ecurity &ecurity ualified as a major reuisite for ban!s and financial institutions, to consider and grant loans and advances. owever, there(s been a complete paradigm shift in the structure. )urrently, lending is based on the evaluation of the actual need of the firms. "inancial viability of a proposal, as a base to grant loans, is now been given precedence over security. "urther, an element of ris! is an imperative in every business decision. )redits, )redits, run a higher ris!, as a part of any decision ma!ing in business and so, Ratio analysis and other uantitative techniues mitigate the ris! to some e#tent by providing a fair and rational assessment of ris!s. Ratio analysis broadly e#plains the process of computing, acts as a vital tool in determination and presentation of the relationship of related items and groups of items of the financial statements. "inancial "inancial position of a unit is concretely and clearly encapsulated by the means of ratio analysis. The signifi significanc cancee of Ratio Ratio *naly *nalysis sis for a holistic holistic "inanci "inancial al *naly *nalysis sis remains remains unflinc unflinching hingly ly supreme. Ratio can be used in the form of percentage, +uotient and Rates. In other words, it can be e#pressed as a to b a- b a is to b/ or as a simple fraction, integer and decimal. * ratio is calculated by dividing one item or figure by another item or figure.
ANALYSIS OF RATIO
Analysis using ratios can be one in !ollo"ing "ays# •
*nalysis of an individual or/ &ingle Ratio
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*nalysis of referring to a 0roup of Ratio
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*nalysis of ratios by Trend
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*nalysis by inter%firm comparison
AD$ANTAGES AD$ANTAGES OF RATIO ANALY ANA LYSIS SIS In order order to establis establish h the relatio relationshi nship p between between two account accounting ing figures, figures, applicatio application n of Ratio Ratio *nalysi *nalysiss is necessary necessary.. *pplicati *pplication on of the same provides provides the signifi significant cant informa information tion to the management or users who can analyse the business situation. It also facilitates meaningful and productive monitoring monito ring of the annual annu al performance of o f the firm. Illustrated below are the advantages ad vantages of ratio analysis•
It facilitates the accounting information information to be summari1ed and simplified simplified in a concise and concrete form which is comprehensible to the user.
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It depicts the inter%relationship between the facts and figures of various segments of business which are instrumental ins trumental in ta!ing important importan t financial decisions.
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Ratio analysis clears all the impediments impediments and inefficiencie inefficienciess related to performance of the firm2individual.
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It euips the management with the reuisite information enables them to ta!e prompt business %decisions. %decision s.
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It helps helps the managem management ent in effecti effectively vely discharg discharging ing its functio functions2o ns2opera peration tionss such as planning, organi1ing, controlling, con trolling, directing and forecasting.
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Ratio analysis provides a detailed account of profitable and unprofitable activities. Thus, the management is able to concentrate on unprofitable activities and consider the necessary steps to overcome the e#istential shortcomings.
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Ratio analysis is used as a benchmar! for effective control of performance of business activities.
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Ratios are an effectual means of communication and informing about financial soundness made by the business concern to the proprietors, investors, creditors and other parties.
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Ratio analysis is an effective tool which is used for measuring the operating results of the enterprises.
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It facilitates control over the operation as well as resources of the business.
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Ratio analysis provides all assistance to the management to discharge responsibilities.
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Ratio analysis aids in accurate determination of the performance of liuidity, profitability and solvency position of the business concern.
LIMITATIONS OF RATIO ANALYSIS •
3arious environmental conditions such as regulation, mar!et structures etc. vary for different companies, operating in different industries. &ignificance of such factors is e#tremely high. This variation may lead to a difference or an element of discrepancy, while comparing the two companies from diverse industries.
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"inancial accounting information is impacted and often subject to change, by estimates and assumptions. *ccounting standards allow scope for incorporating different accounting policies, which impairs comparability and hence functionality of ratio analysis is less in such situations.
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Ratio analysis e#plicates association between past information while current and future information is of more relevance and application to the users.
TY%ES OF ACCOUNTING RATIOS * number of possible ratios can be used to analy1e financial statements, including the following most commonly used accounting ratios-
LIQUIDITY RATIOS show how liuid the organi1ation is. *n organi1ation is liuid if it can pay its bills on time. Three liuidity ratios are4. )urrent Ratio is one of the most commonly used ratios. It is eual to )urrent *ssets divided by )urrent 5iabilities. 6. +uic! Ratio 7 +uic! *ssets 2 )urrent 5iabilities 8. where +uic! *ssets 7 )ash 9 &hort Term &ecurities 9 *ccounts Receivable :. ;et
PROFITABILITY RATIOS show an organi1ation's returns on investments. =rofitability ratios include4. =rofit >argin 7 ;et Income 2 Revenue 6. Return on *ssets 7 ;et Income 2 *verage Total *ssets 8. *verage Total *ssets euals ending plus beginning Total *ssets divided by two :. Return on ?uity 7 ;et Income 2 *verage &toc!holders' ?uity @. *verage &toc!holders' ?uity euals beginning plus ending stoc!holders' euity divided by two. Return on )ommon ?uity is a similar ratio but uses average common stoc!holders' euity.
CAPITAL STRUCTURE RATIOS show how an organi1ation has financed the purchase of assets and include-
4. Aebt to ?uity Ratio 7 Total 5iabilities 2 Total &toc!holders' ?uity 6. Interest )overage Ratio 7 Income $efore Income Ta#es and Interest ?#pense/ 8. Aebt to *sset Ratio 7 Total 5iabilities 2 Total *ssets
MARKET VALUE RATIOS show the value created for shareholders and include4. =rice ?arnings =2?/ ratio 7 =rice per share of common stoc! 2 ?arnings per share 6. Aividend yield 7 =er share dividend 2 =er share price 8. Aividend payout ratio 7 )ommon &toc! )ash Aividends 2 ;et Income :. >ar!et to $oo! Ratio 7 )ommon share mar!et value 2 )ommon share boo! value
ACTIVITY ANALYSIS RATIOS show how efficient the organi1ation has been in using its assets to generate sales and include4. Inventory Turnover Ratio 7 )ost of 0oods &old 2 *verage Inventories 6. *ccounts Receivable Turnover Ratio 7 &ales 2 *verage *ccounts Receivable 8. *ssets Turnover Ratio 7 &ales 2 *verage Total *ssets
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STA&ILITY RATIOS &tability is the long%term counterpart of liuidity. &tability analysis investigates how much debt can be supported by the company and whether debt and euity are balanced. The most common stability ratios are the Aebt%to%?uity ratio and gearing also called leverage/. •
debt%to%euity ratio 7 ;et debt/ 2 &hareholders( euity/
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gearing 7 ;et debt/ 2 ;et debt 9 &hareholders( euity/
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;et debt 7 Interest%bearing debt B ?#cess cash.
;et debt is defined as interest%bearing long%term and short%term debt less e#cess cash in the business. ;ote that only interest%bearing net debt is included here, and other current liabilities are e#cluded as they are short%term and can impact on liuidity, but not stability. ?#cess cash is the cash held on the balance sheet that is not needed and e#ceeds the normal cash level reuired for business operations usually 8C%@C of annual sales/. If you love Dstability ratios( and need a concrete numerical e#ample showing how they are calculated, then you will love our "inancial ratio analysis ?#cel template. $oth ?uity and ;et Aebt should be ta!en at mar!et value as far as possible, otherwise boo! value should be used. $oo! values mostly record historical costs only and not “fair value”. "or debt, unless the company has a high credit ris! or interest rates have changed considerably, the difference between boo! and mar!et value will be small. "or euity, mar!et values are usually considerably higher, at least when the company is operating as a going concern and is not in liuidation. ;ote that while the cost of debt is usually lower than the cost of euity, and a company attempts to minimi1e its cost of capital by using debt, it is unwise and often disastrous to put a company in a situation where it can not pay its interest and meet its redemption payments as they fall due. &o gearing is all about using the right mi# of debt and euity to finance the business in the long term. 7
Aifferent levels of gearing are regarded as normal across various industries, in particular depending on the ability of the business to generate a high level of cash and therefore bring protection from a ris! of default, thereby reducing ris! to debt holders. ?ven within one industry, some companies are more geared than others, especially those with stable profit and assets li!e land and buildings who are unli!ely to fall in value uic!ly over time and therefore provide good security. G* and H>T& licence acuisition. fcom, the HJ telecom regulator, uses a range of 4FC to 8FC as the optimal gearing for a HJ mobile networ! operator, with 4FC being considered as low gearing and 8FC high gearing. )urrently, mobile operators are seen as more ris!y than fi#ed%line or integrated telecom businesses as they are more specialised than integrated operators, and consume more cash, whereas the mar!et dominance of most incumbent fi#ed%networ! operators, especially in voice, is seen as a cash cow and stabili1ing factor. This might change though with the emergence of 3oice over I= and increasing price competition. *ccording to >ichael =omerleano, a
times interest earned also called interest cover ratio/ 7 ?$ITA*/ 2 ;et interest payable/
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debt cover ratio long%term view/ 7 ;et debt/ 2 ?$ITA* 8
The interest cover ratio indicates by how much profit would have to fall until the company is unable to pay its interest. ?$IT and ?$ITA* are ta!en from the =rofit G 5oss account and can be seen as pro#y for respectively )ashflow from operations and )ashflow after investment. &ometimes interest cover is calculated using cashflows from the )ashflow statement. "inally, the debt cover ratio shows how many years of ?$ITA* would be necessary to reimburse company debt principal/ in full. "or telecom networ! operators, a ratio lower than 6 is regarded as acceptable.
TY%ES OF STA&ILITY RATIO &tability Ratios is also called as 5ong% term &olvency Ratios or 5everage Ratios. The leverage ratios may be defined as those financial ratios which measure the long term stability and structure of the firm. These ratios indicate the mi# of funds provided by owners and lenders and assure the lenders of the long term funds with regard toa/ =eriodic payment of interest during the period of the loan and b/ Repayments of principal amount on maturity. 5everage Ratios are of two types'( Ca)ital Structure Ratios an *( Co+erage Ratios#
In )apital &tructure Ratios there are &i# types of Ratios are there which are shown below. 4/ 6/ 8/ :/ @/ K/
?uity Ratio Aebt Ratio Aebt to ?uity Ratio Aebt to Total *ssets Ratio )apital 0earing Ratio =roprietary Ratio.
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*nd in )overage Ratios there are "our types of Ratios are there which are given below. 4/ 6/ 8/ :/
Aebt%&ervice )overage Ratio A&)R/ Interest )overage Ratio =reference Aividend )overage Ratio "i#ed )harges )overage Ratios.
CA%ITAL STRUCTURE RATIOSThe capital structure is how a firm finances its overall operations and growth by using different sources of funds. Aebt comes in the form of bond issues or long%term notes payable, while euity is classified as common stoc! , preferred stoc! or retained earnings. &hort%term debt such as wor!ing capital reuirements is also considered to be part of the capital structure.
&REA,ING DO-N .CA%ITAL STRUCTURE. * firm's capital structure can be a mi#ture of long%term debt, short%term debt, common euity and preferred euity. * company's proportion of short% and long%term debt is considered when analy1ing capital structure.
CA%ITALI/ATION STRUCTURE The proportion of debt and euity in the capital configuration of a company. )apitali1ation structures also refer to the percentage of funds contributed to a firm's total capital employed by euity shareholders, preferred shareholders and debt%holders, in the form of common stoc!, preferred stoc! and debt. * company's capitali1ation structure has a significant bearing on measures of its profitability and financial strength, such as net profit margin, return on euity, debt%euity ratio, interest coverage and so on. )apitali1ation &tructure is also !nown as capital structure. 10
&REA,ING DO-N .CA%ITALI/ATION STRUCTURE.
'( E0UITY RATIO The euity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed by owners' investments by comparing the total euity in the company to the total assets. The euity ratio highlights two important financial concepts of a solvent and sustainable business. The first component shows how much of the total company assets are owned outright by the investors. In other words, after all of the liabilities are paid off, the investors will end up with the remaining assets. The second component inversely shows how leveraged the company is with debt. The euity ratio measures how much of a firm's assets were financed by investors. In other words, this is the investors' sta!e in the company. This is what they are on the hoo! for. The inverse of this calculation shows the amount of assets that were financed by debt. )ompanies with higher euity
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ratios show new investors and creditors that investors believe in the company and are willing to finance it with their investments.
FORMULA1 S2are2olers E3uity
?uity Ratio -
Ca)ital E4)loye
This ratio indicates proportion of owners fund to total fund invested in the business. Traditionally, it is believed that higher the proportion of owners( fund lower is the degree of ris!.
*( DE&T RATIO1 * financial ratio that measures the e#tent of a company(s or consumer(s leverage. The debt ratio is defined as the ratio of total B long%term and short%term B debt to total assets, e#pressed as a decimal or percentage. It can be interpreted as the proportion of a company(s assets that are financed by debt. FORMULA1
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&REA,ING DO-N .DE&T RATIO. The higher this ratio, the more leveraged the company is, implying greater financial ris! . *t the same time, leverage is an important tool that companies use to grow, and many businesses find sustainable uses for debt. Aebt ratios vary widely across industries, with capital%intensive businesses such as utilities and pipelines having much higher debt ratios than other industries li!e technology. "or e#ample, if a company has total assets of L4FF million and total debt of L8F million, its debt ratio is 8FC or F.8F. Is this company in a better financial situation than one with a debt ratio of :FCM The answer depends on the industry. * debt ratio of 8FC may be too high for an industry with volatile cash flows, in which most businesses ta!e on little debt. * company with a high debt ratio relative to its peers would probably find it e#pensive to borrow and could find itself in a crunch if circumstances change. The frac!ing industry, for e#ample, e#perienced tough times beginning in the summer of 6F4:, brought on by high levels of debt and plummeting energy prices. )onversely, a debt level of :FC may be easily manageable for a company in a sector such as utilities, where cash flows are stable and higher debt ratios are the norm. * debt ratio of greater than 4FFC tells you that a company has more debt than assets. >eanwhile, a debt ratio of less than 4FFC indicates that a company has more assets than debt. Hsed in conjunction with other measures of financial health, the debt ratio can help investors determine a company's ris! level. &ome sources define the debt ratio as total liabilities divided by total assets. This reflects a certain ambiguity between the terms NdebtN and NliabilitiesN that depends on the circumstance. The debt%to%euity ratio, for e#ample, is closely related to and more common than the debt ratio, but uses total liabilities in the numerator. In the case of the debt ratio, financial data providers calculate it using only long%term and short%term debt including current portions of long%term debt/, e#cluding liabilities such as accounts payable, negative goodwill and Nother.N The debt ratio is often called the Ndebt%to%assets ratio.N 13
5et's loo! at a few e#amples from different industries to conte#tuali1e the debt ratio. &tarbuc!s )orp. &$HO/ listed L@:E,PFF,FFF in short%term and current portion of long%term debt on its balance sheet for the uarter ending Qune 6P, 6F4@, and L6,8:,:FF,FFF in long%term debt. The company's total assets were L46,PKP,PFF,FFF. This gives us a debt ratio of @:E,PFF,FFF 9 6,8:,:FF,FFF/ S 46,PKP,PFF,FFF 7 F.66@4, or 66.@4C. To assess whether this is high, we should consider the capital e#penditures that go into opening a &tarbuc!s- leasing commercial space, renovating it to fit a certain layout, and purchasing e#pensive specialty euipment, much of which is used infreuently. The company must also hire and train employees in an industry with e#ceptionally high employee turnover, adhere to food safety regulations, etc. for 64,FFF locations, in K@ countries. =erhaps 68C isn't so bad after all, and indeed >orningstar gives the industry average as :FC. The result is that &tarbuc!s has an easy time borrowing money creditors trust that it is in a solid financial position and can be e#pected to pay them bac! in full. "i#ed%rate, non%callable &tarbuc!s bonds with a maturity date in 6F:@ have a coupon rate of :.8C.
service ratio. The gross debt ratio is defined as the ratio of monthly housing costs including mortgage payments, home insurance and property costs/ to monthly income, while the total debt service ratio is the ratio of monthly housing costs plus other debt such as car payments and credit card borrowings to monthly income. *cceptable levels of the total debt service ratio, in percentage terms, range from the mid%8Fs to the low%:Fs.
5( DE&T TO E0UITY RATIO1 Aebt2?uity Ratio is a debt ratio used to measure a company's financial leverage, calculated by dividing a company(s total liabilities by its stoc!holders' euity. The A2? ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders( euity. FORMULA1
Aebt % ?uity Ratio 7 Total 5iabilities 2 &hareholders' ?uity The result may often be e#pressed as a number or as a percentage. This form of A2? may often be referred to as ris! or gearing. 6. This ratio can be applied to personal financial statements as well as corporate ones, in which case it is also !nown as the =ersonal Aebt2?uity Ratio. ere, “euity” refers not to the value of sta!eholders( shares but rather to the difference between the total value of a corporation or individual(s assets and that corporation or individual(s liabilities. The formula for this form o f the A2? ratio, then, can be represented asA2? 7 Total 5iabilities 2 Total *ssets % Total 5iabilities/
&REA,ING DO-N .DE&T6E0UITY RATIO. 4. 0iven that the debt2euity ratio measures a company(s debt relative to the total value of its stoc! , it is most often used to gauge the e#tent to which a company is ta!ing on debts as a means 15
of leveraging attempting to increase its value by using borrowed money to fund various projects/. * high debt2euity ratio generally means that a company has been aggressive in financing its growth with debt. *ggressive leveraging practices are often associated with high levels of ris! . This may result in volatile earnings as a result of the additional interest e#pense. 6. The personal debt2euity ratio is often used in financing, as when an individual or corporation is applying for a loan. This form of A2? essentially measures the dollar amount of debt an individual or corporation has for each dollar of euity they have. A2? is very important to a lender when considering a candidate for a loan, as it can greatly contribute to the lender(s confidence or lac! thereof/ in the candidate(s financial stability. * candidate with a high personal debt2euity ratio has a high amount of debt relative to their available euity, and will not li!ely instill much confidence in the lender in the candidate(s ability to repay the loan. n the other hand, a candidate with a low personal debt2euity ratio has relatively low debt, and thus poses much less ris! to the lender should the lender agree to provide the loan, as the candidate would appear to have a reasonable ability to repay the loan.
LIMITATIONS OF .DE&T6E0UITY RATIO. 5i!e with most ratios, when using the debt2euity ratio it is very important to consider the industry in which the company operates. $ecause different industries rely on different amounts of capital to operate and use that capital in different ways, a relatively high A2? ratio may be common in one industry while a relatively low A2? may be common in another. "or e#ample, capital%intensive industries such as auto manufacturing tend to have a debt2euity ratio above 6, while companies li!e personal computer manufacturers usually are not particularly capital intensive and may often have a debt2euity ratio of under F.@. *s such, A2? ratios should only be used to compare companies when those companies operate within the same industry. *nother important point to consider when assessing A2? ratios is that the “Total 5iabilities” portion of the formula may often be determined in a variety of ways by different companies, some of which are not actually the sum of all of the company(s liabilities. In some cases, companies will only incorporate debts li!e loans and debt securities/ into the liabilities portion of the formula, while omitting other !inds of liabilities unearned revenue, etc./. In other cases, companies may calculate A2? in an even more specific way, including only long%term debts and 16
e#cluding short%term debts and other liabilities. et, “long%term debt” here is not necessarily a term with a consistent meaning. It may include all long%term debts, but it may also e#clude long% term debts nearing maturity, which are then categori1ed as “short%term” debts. $ecause of these differentiations, when considering a company(s A2? ratio one should try to determine how the ratio was calculated and should be sure to consider other ratios and performance metrics as well.
7( DE&T TO TOTAL ASSETS RATIO Total debt to total assets is a leverage ratio that defines the total amount of debt relative to assets. This enables comparisons of leverage to be made across different companies. The higher the ratio, the higher the degree of leverage, and conseuently, financial ris!. This is a broad ratio that includes long%term and short%term debt borrowings maturing within one year/, as well as all assets B tangible and intangible. FORMULA -
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&REA,ING DO-N .TOTAL DE&T TO TOTAL ASSETS. "or e#ample, assume hypothetical company 5evered )o. has L:F million in long%term debt, L4F million in short%term debt, and L4FF million in total assets. 5evered )o. would therefore have a total debt to total assets ratio of F.@. n the other hand, if rival 5ow5evered )o. has L@ million in long%term debt, L@ million in short%term debt, and L@F million in total assets, its total debt to total assets ratio would be F.6. "rom the above e#ample, @FC of 5evered )o.(s assets have been financed by debt, while only 6FC of 5ow5evered )o.(s assets were. 5evered )o. has a much higher degree of leverage than 5ow5evered )o., and therefore a lower degree of financial fle#ibility. This is because debt servicing payments have to be made under all circumstances, otherwise the company would breach debt covenants and run the ris! of being forced into ban!ruptcy by creditors.
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8( CA%ITAL GEARING RATIO1 )apital gearing is the degree to which a company acuires assets or to which it funds its ongoing operations with long% or short%term debt. )apital gearing will differ between companies and industries,andwilloftenchangeovertime.
)apital gearing is also !nown as Nfinancial leverageN. FORMULA1
)0* 7
=reference &hare )apital 9 Aebentures 9 ther $orrowed funds/ ?uity &hare )apital 9 Reserves G &urplus B 5osses/
&REA,ING DO-N .CA%ITAL GEARING. In the event of a leveraged buyout, the amount of capital gearing a company will employ will dramatically increase as the company increases its debt in order to finance the acuisition.
9( %RO%RIETARY RATIO 1 The proprietary ratio also !nown as net worth ratio or euity ratio/ is used to evaluate the soundness of the capital structure of a company. It is computed by dividing the stoc!holders( euity by total assets.
FORMULA1
&ome analysts prefer to e#clude intangible assets goodwill etc./ from the denominator of the above formula. In that case, the formula would be written as follows19
The information about stoc!holders( euity and assets is available from balance sheet. E:a4)le1
Total assets Intangible assets &toc!holder(s euity
L E@F,FFF 4@F,FFF ::F,FFF
"rom the above information we can compute proprietary ratio as follows-
7 ::F,FFF 2 PFF,FFF / U 4FF 7 @@C The proprietary ratio is @@C. It means stoc!holders( has contributed @@C of the total tangible assets. The remaining :@C have been contributed by creditors.
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SIGNIFICANCE AND INTER%RETATION1 The proprietary ratio shows the contribution of stoc!holders( in total capital of the company. * high proprietary ratio, therefore, indicates a strong financial position of the company and greater security for creditors. * low ratio indicates that the company is already heavily depending on debts for its operations. * large portion of debts in the total capital may reduce creditors interest, increase interest e#penses and also the ris! of ban!ruptcy. aving a very high proprietary ratio does not always mean that the company has an ideal capital structure. * company with a very high proprietary ratio may not be ta!ing full advantage of debt financing for its operations that is also not a good sign for the stoc!holders.
CO$ERAGE RATIOS1 The coverage ratios measure the firm(s ability to service the fi#ed liabilities. These ratios establish the relationship between fi#ed claims and what is normally available out of which these claims are to be paid. The fi#ed claims consist of a/ Interest on loans. b/ =reference dividend c/ *morti1ation of principal or repayment of the installment of loans or redemption of preference capital on maturity.
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The following are important coverage ratios-
'( DE&T SER$ICE CO$ERAGE RATIO ;DSCR(1 In corporate finance, the Aebt%&ervice )overage Ratio A&)R/ is a measure of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sin!ing%fund and lease payments. In government finance, it is the amount of e#port earnings needed to meet annual interest and principal payments on a country's e#ternal debts. In personal finance, it is a ratio used by ban! loan officers to determine income property loans. * A&)R greater than 4 means the entity B whether a person, company or government B has sufficient income to pay its current debt obligations. * A&)R less than 4 means it does not.
FORMULA1 DSCR < Net O)erating Inco4e 6 Total Debt Ser+ice
&REA,ING
DO-N
.DE&T=SER$ICE
CO$ERAGE
RATIO
;DSCR(. * A&)R of less than 4 means negative cash flow. * A&)R of .E@ means that there is only enough net operating income to cover E@C of annual debt payments. "or e#ample, in the conte#t of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to !eep the project afloat. In general, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income. ;et operating income is a company's revenue minus its operating e#penses, not including ta#es and interest payments. It is often considered euivalent to earnings before interest and ta# ?$IT/. &ome calculations include non%operating income in ?$IT, however, which is never the case for net operating income. *s a lender or investor comparing different companies' credit% 22
worthiness B or a manager comparing different years' or uarters' B it is important to apply consistent criteria when calculating A&)R. *s a borrower, it is important to reali1e that lenders may calculate A&)R in slightly different ways. Total debt service refers to current debt obligations, meaning any interest, principal, sin!ing%fund and lease payments that are due in the coming year. n a balance sheet, this will include short% term debt and the current portion of long%term debt. Income ta#es complicate A&)R calculations, because interest payments are ta# deductible, while principle repayments are not. * more accurate way to calculate total debt service is thereforeInterest > ;%rinci)le 6 ?' = Ta: Rate@(
5enders will routinely assess a borrower's A&)R before ma!ing a loan. If the ratio is less than 4, the borrower is unable to pay current debt obligations without drawing on outside sourcesV without, in essence, borrowing more. If it is too close to 4, say 4.4, the entity is vulnerable, and a minor decline in cash flow could ma!e it unable to service its debt. 5enders may in some cases reuire that the borrower maintain a certain minimum A&)R while the loan is outstanding. &ome agreements will consider a borrower who falls below that minimum to be in default. The minimum A&)R a lender will demand can depend on macroeconomic conditions. If the economy is growing, credit is more readily available, and lenders may be more forgiving of lower ratios. * broad tendency to lend to less%ualified borrowers can in turn affect the economy's stability, however, as happened leading up to the 6FFP financial crisis. &ubprime borrowers were able to obtain credit, especially mortgages, with little scrutiny.
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*( INTEREST CO$ERAGE RATIO 5(
The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio may be calculated by dividing a company's earnings before interest and ta#es ?$IT/ during a given period by the amount a company must pay in interest on its debts during the same period.
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The method for calculating interest coverage ratio may be represented with the following formula-
8( 9( (
Interest coverage ratio is also often called “times interest earned.”
B( &REA,ING DO-N .INTEREST CO$ERAGE RATIO. (
?ssentially, the interest coverage ratio measures how many times over a company could pay its current interest payment with its available earnings. In other words, it measures the margin of safety a company has for paying interest during a given period, which a company needs in order to survive future and perhaps unforeseeable/ financial hardship should it arise. * company(s ability to meet its interest obligations is an aspect of a company(s solvency, and is thus a very important factor in the return for shareholders.
'(
To provide an e#ample of how to calculate interest coverage ratio, suppose that a
company(s earnings during a given uarter are LK6@,FFF and that it has debts upon which it is liable for payments of L8F,FFF every month. To calculate the interest coverage ratio here, one would need to convert the monthly interest payments into uarterly payments by multiplying them by three. The interest coverage ratio for the company is then K.E: WLK6@,FFF 2 L8F,FFF # 8/ 7 LK6@,FFF 2 LEF,FFF 7 K.E:X. 24
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&taying above water with paying interest is a critical and ongoing concern for any
company. *s soon as a company struggles with this, it may have to borrow further or dip into its cash, which is much better used to invest in capital assets or held as reserves for emergencies.
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The lower a company(s interest coverage ratio is, the more its debt e#penses burden the
company.
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>oreover, an interest coverage ratio below 4 indicates the company is not generating
sufficient revenues to satisfy its interest e#penses. If a company(s ratio is below 4, it will li!ely need to spend some of its cash reserves in order to meet the difference or borrow more, which will be difficult for reasons stated above. therwise, even if earnings are low for a single month, the company ris!s falling into ban!ruptcy.
'7(
0enerally, an interest coverage ratio of 6.@ is often considered to be a warning sign,
indicating that the company should be careful not to dip further.
'8(
?ven though it creates debt and interest, borrowing has the potential to positively affect a
company(s profitability through the development of capital assets according to the cost% benefit analysis. $ut a company must also be smart in its borrowing. $ecause interest affects a company(s profitability as well, a company should only ta!e a loan if it !nows it will have a good handle on its interest payments for years to come. * good interest coverage ratio would serve as a good indicator of this circumstance, and potentially as an indicator of the company(s ability to pay off the debt itself as well. 5arge corporations, however, may often have both high interest coverage ratios and very large borrowings.
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$usinesses may often survive for a very long time while only paying off their interest
payments and not the debt itself. et, this is often considered a dangerous practice, particularly if the company is relatively small and thus has low revenue compared to larger companies. >oreover, paying off the debt helps pay off interest down the road, as with reduced debt the interest rate may be adjusted as well.
'( %REFERENCE DI$IDEND CO$ERAGE RATIO1 'B(
This ratio measures the ability of a firm to pay dividend on preference shares which carry
a states rate of return. This ratio is computed as-
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FORMULA 1
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=reference Aividend )overage Ratio 7 ;et =rofit 2 ?arning after Ta#es ?*T/
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=reference dividend liability
?arnings after ta# is considered because unli!e debt on which interest is charged on the
profit of the firm, the preference dividend is treated as appropriation of profit.
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This ratio indicates margin of safety available to the preference shareholders. * higher
ratio is desirable from preference shareholders point of view.
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&imilarly E0UITY DI$IDEND CO$ERAGE RATIO can also be calculated ta!ing
?*T B =ref. Aividend/ and euity fund figures into consideration.
*8( FIED CARGES CO$ERAGE RATIO 1 *9(
This ratio shows how many times the cash flow before interest and ta#es covers all fi#ed
financing charges. This ratio is more than 4 is considered as safe.
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"i#ed )harges )overage Ratio 7
?$IT 9 Aepreciation 26
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Interest 9 Repayment of loan 2 4 B ta# rate
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