LOS J requires us to:
calculate and interpret leverage and coverage ratios
The calculation and interpretation of the leverage and coverage ratios are discussed in the chapter ‘Financial Analysis Technique’. The discussion below is just a repetition.
The ratios can be classified into five categories i.e. activity ratios, liquidity ratios, solvency ratios, profitability ratios, and valuation ratios. These are discussed in detail in the following sub-sections.
1. Activity Ratios
Activity Ratios are the measure of the efficiency of a firm. It measures the degree of efficiency with which a firm manages its assets and the operating efficiency of the firm. These ratios measure the ongoing operational performance of the firm.
Some of the activity ratios and their respective formulas are:
Ratio |
Formula |
Description |
Inventory Turnover Ratio |
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This ratio shows the number of times the inventory is sold and replaced over the reporting period. |
Days of Inventory on Hand |
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This ratio measures the number of days a firm takes to sell its average balance of inventory. |
Receivables Turnover Ratio |
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This ratio represents the number of times in a year a business collects its accounts receivables. |
Days of Sales Outstanding |
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It measures the number of days a firm takes to collect its revenues/receivables after the sales have been made. |
Payables Turnover Ratio |
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This ratio represents the number of times in a year a business pays to its accounts payables. |
Number of Days of Payable |
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It measures the number of days a firm takes to pay its creditors after the purchases have been made. |
Working Capital Turnover |
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This ratio shows the amount of revenues generated per dollar of investment in the working capital. |
Fixed Assets Turnover Ratio |
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It shows the amount of revenues generated per dollar of investment in the fixed assets. |
Total Assets Turnover |
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This ratio shows the amount of revenues generated per dollar of investment in the total assets of the firm. |
2. Liquidity Ratios
The liquidity ratio is the measure of the company’s ability to pay the short-term debt and other obligations. Some of the important liquidity ratios and their formulas are:
Ratio |
Formula |
Description |
Current Ratio |
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This ratio shows the company’s ability to pay the short-term liabilities with the current assets. |
Quick Ratio |
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This ratio measures the ability of the quick assets of the company is paying the short-term obligations. |
Cash Ratio |
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This ratio measures the firm’s ability to pay its liabilities using its cash and marketable securities. |
Defensive Internal Ratio |
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This ratio measures the number of days a firm can survive having access to the non-current assets. |
Cash Conversion Cycle |
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This ratio measures the speed with which the company can convert cash in hand to sales and accounts receivable and then back to cash through receivables. |
3. Solvency Ratios
The solvency ratios measure the company’s ability to pay its long-term debt obligations. Some of the important solvency ratios and their formulas are:
Ratio |
Formula |
Description |
Debt-to-Assets Ratio |
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This ratio shows the company’s ability to pay all its liabilities with the total assets. |
Debt-to-Capital Ratio |
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This ratio measures the firm’s ability to pay off its debt through its capital. |
Debt-to-Equity Ratio |
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This ratio measures the firm’s ability to meet its debt obligation with the help of its equity capital. |
Financial Leverage |
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This ratio measures the amount of assets that are financed through the equity capital of the company. |
Interest Coverage Ratio |
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This ratio measures if the earnings of the company are sufficient to cover the interest payments. |
Fixed Charge Coverage |
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This ratio measures the ability of the company to pay for its fixed charges through its earnings. |
4. Profitability Ratios
Profitability ratios measure the ability of the firm to generate profits. Profitability can be measured in two ways i.e. the profits generated per unit of sales and profits generated per unit of assets. Some of the measures of profitability ratios and their formulas are:
Ratio |
Formula |
Description |
Gross Profit Margin |
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This ratio measures the gross profits earned per dollar of sales. |
Operating Profit Margin |
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This ratio measures the amount of operating profit earned per dollar of sales. |
Pre-Tax Margin |
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This ratio measures the amount of pre-tax profit earned per dollar of sales. |
Net Profit Margin |
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This ratio measures the net profits earned per dollar of sales. |
Operating Return on Assets |
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This ratio measures the operating profits earned per dollar of average asset held. |
Return on Assets |
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This ratio measures the net income earned per dollar of investment in average total assets held during the year. |
Return to Total Capital |
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This ratio measures the earnings per dollar of capital (both debt and equity) invested. |
ROE |
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This ratio measures the return to the shareholders on their per dollar of investments (in terms of the face value of shares). |
Return to Common Equity |
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This ratio measures the returns earned by the holders of common shares during the year. |
NOTE: By comparing the ratios of two or more companies we can get a fair idea about which one is comparatively more solvent, or the one which is more profitable and a better performing company. But it does not give the information as to which one is the better investment option. For evaluating the investment suitability, one should value the share or debentures of the company and go for investment in the one that looks more undervalued.