May 19 ,2021 /
Complinova Team /
A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization.
Financial ratios are useful tools that help business managers and investors analyse and compare financial relationships between the accounts on the firm's financial statements.
Leverage, Coverage & Solvency Ratios:
A coverage ratio, broadly, is a metric intended to measure a company's ability to service its debt and meet its financial obligations, such as interest payments or dividends. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company's financial position.
- Debt Equity / Leverage Ratio
- The debt-to-equity or D/E ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage.
- It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds.
D/E Ratio = (Short Term Debt + Long Term Debt + Other Repayment Obligations) / Shareholder’s Equity
- Given that the D/E ratio measures a company’s debt relative to the value of its net assets, it is most often used to gauge the extent to which a company is taking on debt as a means of leveraging its assets. A high D/E ratio is often associated with high risk; it means that a company has been aggressive in financing its growth with debt.
- A ratio of 1 would imply that creditors and investors are on equal footing in the company’s assets. A D/E of 2:1 is an acceptable norm in the manufacturing industry.
- Interest Coverage Ratio
- The interest coverage ratio measures the ability of a company to pay the interest expense on its debt. The ratio, also known as the times interest earned ratio, is defined as:
- Interest Coverage Ratio = Earnings before interest and taxes / Interest Expense
- Interest Coverage Ratio = Earnings before interest and taxes / Interest Expense
- Debt Service Coverage Ratio
- The debt service coverage ratio (DSCR) measures how well a company is able to pay its entire debt service. Debt service includes all principal and interest payments due to be made in the near term. The ratio is defined as: DSCR = Net Operating Income / Total Debt Service
- A ratio of one or above is indicative that a company generates sufficient earnings to completely cover its debt obligations.
- Asset Coverage Ratio
- The asset coverage ratio is similar in nature to the debt service coverage ratio but looks at balance sheet assets instead of comparing income to debt levels. The ratio is defined as:
Asset Coverage Ratio = (Total Assets - Short-term Liabilities) / Total Debt
- Where Total Assets = Tangibles, such as land, buildings, machinery, and inventory
- As a rule of thumb, utility companies should have an asset coverage ratio of at least 1.5, and industrial companies should have an asset coverage ratio of at least 2.
- Solvency Ratio
- The solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt obligations and is used often by prospective business lenders. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
Solvency Ratio = Cash Profit / Total Borrowings
- Example: Total Cash profit is Rs 100. and Total Borrowing at year end is Rs. 500, Solvency Ratio is 20%. This means, it may take 5 years to repay the principal.