Documentos de Académico
Documentos de Profesional
Documentos de Cultura
The term ratio analysis refers to the analysis of the 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.
ANALYSIS OF RATIO
Analysis using ratios can be done in following ways.
It depicts the inter-relationship between the facts and figures of various segments of
business which are instrumental in taking important financial decisions.
Ratio analysis clears all the impediments and inefficiencies related to performance of the
firm/individual.
It equips the management with the requisite information enables them to take prompt
business -decisions.
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 existential shortcomings.
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.
Ratio analysis is an effective tool which is used for measuring the operating results of the
enterprises.
Various environmental conditions such as regulation, market structures etc. vary for
different companies, operating in different industries. Significance of such factors is extremely
high. This variation may lead to a difference or an element of discrepancy, while comparing the
two companies from diverse industries.
Ratio analysis explicates association between past information while current and future
information is of more relevance and application to the users.
LIQUIDITY RATIOS show how liquid the organization is. An organization is liquid if it can
pay its bills on time. Three liquidity ratios are:
1. Current Ratio is one of the most commonly used ratios. It is equal to Current Assets
divided by Current Liabilities.
2. Quick Ratio = Quick Assets / Current Liabilities
3. where Quick Assets = Cash + Short Term Securities + Accounts Receivable
4. Net Working Capital Ratio = (Current Assets - Current Liabilities) / Total Assets
CAPITAL STRUCTURE RATIOS show how an organization has financed the purchase of
assets and include:
MARKET VALUE RATIOS show the value created for shareholders and include:
1. Price Earnings (P/E) ratio = Price per share of common stock / Earnings per share
2. Dividend yield = Per share dividend / Per share price
3. Dividend payout ratio = Common Stock Cash Dividends / Net Income
4. Market to Book Ratio = Common share market value / Common share book value
ACTIVITY ANALYSIS RATIOS show how efficient the organization has been in using its
assets to generate sales and include:
1. Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
2. Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable
3. Assets Turnover Ratio = Sales / Average Total Assets
STABILITY RATIOS
Stability is the long-term counterpart of liquidity. Stability analysis investigates how much debt
can be supported by the company and whether debt and equity are balanced. The most common
stability ratios are the Debt-to-Equity ratio and gearing (also called leverage).
Net debt is defined as interest-bearing long-term and short-term debt less excess cash in the
business. Note that only interest-bearing net debt is included here, and other current liabilities are
excluded as they are short-term and can impact on liquidity, but not stability. Excess cash is the
cash held on the balance sheet that is not needed and exceeds the normal cash level required for
business operations (usually 3%-5% of annual sales).
If you love stability ratios and need a concrete numerical example showing how they are
calculated, then you will love our Financial ratio analysis Excel template.
Both Equity and Net Debt should be taken at market value as far as possible, otherwise book
value should be used. Book values mostly record historical costs only and not fair value. For
debt, unless the company has a high credit risk or interest rates have changed considerably, the
difference between book and market value will be small. For equity, market values are usually
considerably higher, at least when the company is operating as a going concern and is not in
liquidation.
Note that while the cost of debt is usually lower than the cost of equity, and a company attempts
to minimize 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. So
gearing is all about using the right mix of debt and equity to finance the business in the long
term.
7
Different 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 risk of default, thereby reducing risk to debt holders. Even within one industry,
some companies are more geared than others, especially those with stable profit and assets like
land and buildings who are unlikely to fall in value quickly over time and therefore provide good
security. When a companys gearing is outside of the usual industry range, its debt can be
expected to be downgraded, thereby increasing the cost of debt.
Gearing also varies with time and might temporarily differ from a target gearing. For instance, in
the early 1990s an average gearing of 25% was typical for fixed network telecom operators in
Western countries, whereas in 2005, gearing of 30%-40% was common for integrated allpurpose operators, reflecting the stronger acceptance in the industry for higher level of debt as
well as the high debt level of operators that had engaged in expensive M&A and UMTS licence
acquisition. Ofcom, the UK telecom regulator, uses a range of 10% to 30% as the optimal
gearing for a UK mobile network operator, with 10% being considered as low gearing and 30%
high gearing. Currently, mobile operators are seen as more risky than fixed-line or integrated
telecom businesses as they are more specialised than integrated operators, and consume more
cash, whereas the market dominance of most incumbent fixed-network operators, especially in
voice, is seen as a cash cow and stabilizing factor. This might change though with the emergence
of Voice over IP and increasing price competition.
According to Michael Pomerleano, a World Bank economist, gearing also varies by geographic
zone, with gearing being typically lower in Latin Americas, which have often less access to debt
in their own capital markets, but higher in Asian countries, where governments have encouraged
state-owned banks to lend to companies without being too strict on their creditworthiness.
Other useful ratios here from a debt holder perspective are the interest cover ratio (also called
times interest earned), the times burdened covered and the debt cover ratio.
times interest earned (also called interest cover ratio) = EBIT(DA) / (Net interest
payable)
The interest cover ratio indicates by how much profit would have to fall until the company is
unable to pay its interest. EBIT and EBITDA are taken from the Profit & Loss account and can
be seen as proxy for respectively Cashflow from operations and Cashflow after investment.
Sometimes interest cover is calculated using cashflows from the Cashflow statement.
Finally, the debt cover ratio shows how many years of EBITDA would be necessary to reimburse
company debt (principal) in full. For telecom network operators, a ratio lower than 2 is regarded
as acceptable.
Equity Ratio
Debt Ratio
Debt to Equity Ratio
Debt to Total Assets Ratio
Capital Gearing Ratio
Proprietary Ratio.
And in Coverage Ratios there are Four types of Ratios are there which are given below.
1)
2)
3)
4)
CAPITALIZATION STRUCTURE
The proportion of debt and equity in the capital configuration of a company. Capitalization
structures also refer to the percentage of funds contributed to a firm's total capital employed by
equity shareholders, preferred shareholders and debt-holders, in the form of common stock,
preferred stock and debt. A company's capitalization structure has a significant bearing on
measures of its profitability and financial strength, such as net profit margin, return on equity,
debt-equity ratio, interest coverage and so on. Capitalization Structure is also known as capital
structure.
10
1) EQUITY RATIO :
The equity ratio is an investment leverage or solvency ratio that measures the amount of assets
that are financed by owners' investments by comparing the total equity in the company to the
total assets.
The equity 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 equity
ratio measures how much of a firm's assets were financed by investors. In other words, this is the
investors' stake in the company. This is what they are on the hook for. The inverse of this
calculation shows the amount of assets that were financed by debt. Companies with higher equity
11
ratios show new investors and creditors that investors believe in the company and are willing to
finance it with their investments.
FORMULA:
Shareholders Equity
Equity Ratio :
Capital Employed
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 risk.
2) DEBT RATIO:
A financial ratio that measures the extent of a companys or consumers leverage. The debt ratio
is defined as the ratio of total long-term and short-term debt to total assets, expressed as a
decimal or percentage. It can be interpreted as the proportion of a companys assets that are
financed by debt.
FORMULA:
12
Let's look at a few examples from different industries to contextualize the debt ratio. Starbucks
Corp. (SBUX) listed $549,800,000 in short-term and current portion of long-term debt on its
balance sheet for the quarter ending June 28, 2015, and $2,347,400,000 in long-term debt. The
company's total assets were $12,868,800,000. This gives us a debt ratio of (549,800,000
+ 2,347,400,000) 12,868,800,000 = 0.2251, or 22.51%.
To assess whether this is high, we should consider the capital expenditures that go into opening a
Starbucks: leasing commercial space, renovating it to fit a certain layout, and purchasing
expensive specialty equipment, much of which is used infrequently. The company must also hire
and train employees in an industry with exceptionally high employee turnover, adhere to food
safety regulations, etc. for 21,000 locations, in 65 countries. Perhaps 23% isn't so bad after all,
and indeed Morningstar gives the industry average as 40%.
The result is that Starbucks has an easy time borrowing money; creditors trust that it is in a solid
financial position and can be expected to pay them back in full. Fixed-rate, non-callable
Starbucks bonds with a maturity date in 2045 have a coupon rate of 4.3%.
What about a technology company? For the quarter ending June 30, 2015, Facebook Inc. (FB)
reported its short-term and current portion of long-term debt as $221,000,000; its long-term debt
was $110,000,000; its total assets were $44,130,000,000. (221,000,000 + 110,000,000)
44,130,000,000 = 0.0075, or 0.75%. Facebook does not borrow on the corporate bond market. It
has an easy enough time raising capital through stock.
Finally, let's look at a basic materials company, the St. Louis-based miner Arch Coal Inc. (ACI).
For the quarter ending June 30, 2015, the company posted short-term and current portions of
long-term debt of $31,763,000, long-term debt of $5,114,581,000 and total assets of
$8,036,355,000. Coal mining is extremely capital-intensive, so the industry is forgiving of
leverage: the average debt ratio is 47%. Even in this cohort, though, Arch Coal is heavily
indebted; its debt ratio is 64%. Predictably, this makes borrowing expensive. Arch Coal's fixed,
non-callable bonds with a maturity date in 2023 carry a hefty coupon rate of 12.0%
In the consumer lending and mortgages business, two common debt ratios are used to assess a
borrowers ability to repay a loan or mortgage are the gross debt service ratio and the total debt
14
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. Acceptable levels of the total debt service ratio, in
percentage terms, range from the mid-30s to the low-40s.
of leveraging (attempting to increase its value by using borrowed money to fund various
projects). A high debt/equity ratio generally means that a company has been aggressive in
financing its growth with debt. Aggressive leveraging practices are often associated with high
levels of risk. This may result in volatile earnings as a result of the additional interest expense.
2. The personal debt/equity ratio is often used in financing, as when an individual or corporation
is applying for a loan. This form of D/E essentially measures the dollar amount of debt an
individual or corporation has for each dollar of equity they have. D/E is very important to a
lender when considering a candidate for a loan, as it can greatly contribute to the lenders
confidence (or lack thereof) in the candidates financial stability. A candidate with a high
personal debt/equity ratio has a high amount of debt relative to their available equity, and will
not likely instill much confidence in the lender in the candidates ability to repay the loan. On the
other hand, a candidate with a low personal debt/equity ratio has relatively low debt, and thus
poses much less risk 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.
excluding short-term debts and other liabilities. Yet, long-term debt here is not necessarily a
term with a consistent meaning. It may include all long-term debts, but it may also exclude longterm debts nearing maturity, which are then categorized as short-term debts. Because of these
differentiations, when considering a companys D/E ratio one should try to determine how the
ratio was calculated and should be sure to consider other ratios and performance metrics as well.
17
18
6) PROPRIETARY RATIO :
The proprietary ratio (also known as net worth ratio or equity ratio) is used to evaluate the
soundness of the capital structure of a company. It is computed by dividing the stockholders
equity by total assets.
FORMULA:
Some analysts prefer to exclude intangible assets (goodwill etc.) from the denominator of the
above formula. In that case, the formula would be written as follows:
19
The information about stockholders equity and assets is available from balance sheet.
Example:
Total assets
Intangible assets
Stockholders
equity
$ 950,000
150,000
440,000
20
COVERAGE RATIOS:
The coverage ratios measure the firms ability to service the fixed liabilities. These ratios
establish the relationship between fixed claims and what is normally available out of which these
claims are to be paid. The fixed claims consist of;
a) Interest on loans.
b) Preference dividend
c) Amortization of principal or repayment of the installment of loans or redemption of preference
capital on maturity.
21
FORMULA:
DSCR = Net Operating Income / Total Debt Service
23
4) The method for calculating interest coverage ratio may be represented with the following
formula:
5)
6)
7) Interest coverage ratio is also often called times interest earned.
8) BREAKING DOWN 'INTEREST COVERAGE RATIO'
9) Essentially, 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. A companys ability to meet its interest obligations is an aspect of a companys
solvency, and is thus a very important factor in the return for shareholders.
10)
companys earnings during a given quarter are $625,000 and that it has debts upon which it
is liable for payments of $30,000 every month. To calculate the interest coverage ratio here,
one would need to convert the monthly interest payments into quarterly payments by
multiplying them by three. The interest coverage ratio for the company is then 6.94
[$625,000 / ($30,000 x 3) = $625,000 / $90,000 = 6.94].
24
11)
Staying above water with paying interest is a critical and ongoing concern for any
company. As 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.
12)
The lower a companys interest coverage ratio is, the more its debt expenses burden the
company. When a company's interest coverage ratio is 1.5 or lower, its ability to meet
interest expenses may be questionable. 1.5 is generally considered to be a bare minimum
acceptable ratio for a company and a tipping point below which lenders will likely refuse to
lend the company more money, as the companys risk for default is too high.
13)
Moreover, an interest coverage ratio below 1 indicates the company is not generating
sufficient revenues to satisfy its interest expenses. If a companys ratio is below 1, it will
likely 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. Otherwise, even if earnings are low
for a single month, the company risks falling into bankruptcy.
14)
15)
Even though it creates debt and interest, borrowing has the potential to positively affect a
companys profitability through the development of capital assets according to the costbenefit analysis. But a company must also be smart in its borrowing. Because interest affects
a companys profitability as well, a company should only take a loan if it knows it will have
a good handle on its interest payments for years to come. A good interest coverage ratio
would serve as a good indicator of this circumstance, and potentially as an indicator of the
companys ability to pay off the debt itself as well. Large corporations, however, may often
have both high interest coverage ratios and very large borrowings. With the ability to pay off
large interest payments on a regular basis, large companies may continue to borrow without
much worry.
25
16)
Businesses may often survive for a very long time while only paying off their interest
payments and not the debt itself. Yet, this is often considered a dangerous practice,
particularly if the company is relatively small and thus has low revenue compared to larger
companies. Moreover, paying off the debt helps pay off interest down the road, as with
reduced debt the interest rate may be adjusted as well.
This ratio measures the ability of a firm to pay dividend on preference shares which carry
19) FORMULA :
20)
Preference Dividend Coverage Ratio = Net Profit / Earning after Taxes ( EAT)
21)
22)
23)
This ratio indicates margin of safety available to the preference shareholders. A higher
24)
This ratio shows how many times the cash flow before interest and taxes covers all fixed
27)
EBIT + Depreciation
26
28)
29)
30)
31) BIBLIOGRAPHY
32) 1) http://www.business-planning-for-managers.com/main-courses/finance/ratios/stabilityratios.
33) 2) http://www.myaccountingcourse.com/financial-ratios/equity-ratio.
34) 3) http://www.accountingformanagement.org/proprietaryratio.
35)
4) www.investopedia.com/terms/c/capitalgearing.asp
36) 5) http://www.investopedia.com/terms/d/dscr.asp
37) 6) Study Material ( IPCC Module 1-2)
38) 7)
39)
27