INTRODUCTION

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.

MEANING AND DEFINITION OF RATIO ANALYSIS

Ratio analysis is a conceptual technique which dates back to the inception of accounting, as a
concept. Financial analysis as a scientific tool is used to carry out the calculations in the area of
accounting. In order to appraise the valid and existent worth of an enterprise, financial tool comes
handy, regularly. Besides, it also allows the firms to observe the performance spanning across a
long period of time along with the impediments and shortcomings. Financial analysis is an
essential mechanism for a clear interpretation of financial statements. It aids the process of
discovering, the existence of any cross-sectional and time series linkages between various ratios.
Formerly, Security qualified as a major requisite for banks and financial institutions, to consider
and grant loans and advances. However, theres been a complete paradigm shift in the structure.
Currently, lending is based on the evaluation of the actual need of the firms. Financial viability of
a proposal, as a base to grant loans, is now been given precedence over security. Further, an
element of risk is an imperative in every business decision. Credits, run a higher risk, as a part of
any decision making in business and so, Ratio analysis and other quantitative techniques mitigate
the risk to some extent by providing a fair and rational assessment of risks.
Ratio analysis broadly explains 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.
Financial position of a unit is concretely and clearly encapsulated by the means of ratio analysis.
The significance of Ratio Analysis for a holistic Financial Analysis remains unflinchingly
supreme.
Ratio can be used in the form of percentage, Quotient and Rates. In other words, it can be
expressed as a to b; a: b (a is to b) or as a simple fraction, integer and decimal. A ratio is
calculated by dividing one item or figure by another item or figure.
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ANALYSIS OF RATIO
Analysis using ratios can be done in following ways.

Analysis of an individual (or) Single Ratio

Analysis of referring to a Group of Ratio

Analysis of ratios by Trend

Analysis by inter-firm comparison

ADVANTAGES OF RATIO ANALYSIS

In order to establish the relationship between two accounting figures, application of Ratio
Analysis is necessary. Application of the same provides the significant information to the
management or users who can analyse the business situation. It also facilitates meaningful and
productive monitoring of the annual performance of the firm. Illustrated below are the advantages
of ratio analysis:

It facilitates the accounting information to be summarized and simplified in a concise and

concrete form which is comprehensible to the user.

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.

It helps the management in effectively discharging its functions/operations such as

planning, organizing, controlling, directing and forecasting.

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.

Ratio analysis is used as a benchmark for effective control of performance of business

activities.

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.

It facilitates control over the operation as well as resources of the business.

Ratio analysis provides all assistance to the management to discharge responsibilities.

Ratio analysis aids in accurate determination of the performance of liquidity, profitability

and solvency position of the business concern.

LIMITATIONS OF RATIO ANALYSIS

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.

Financial accounting information is impacted and often subject to change, by estimates

and assumptions. Accounting standards allow scope for incorporating different accounting
policies, which impairs comparability and hence functionality of ratio analysis is less in such
situations.

Ratio analysis explicates association between past information while current and future
information is of more relevance and application to the users.

TYPES OF ACCOUNTING RATIOS

A number of possible ratios can be used to analyze financial statements, including the following
most commonly used accounting ratios:

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

PROFITABILITY RATIOS show an organization's returns on investments. Profitability

ratios include:
1. Profit Margin = Net Income / Revenue
2. Return on Assets = Net Income / Average Total Assets
3. Average Total Assets equals ending plus beginning Total Assets divided by two
4. Return on Equity = Net Income / Average Stockholders' Equity
5. Average Stockholders' Equity equals beginning plus ending stockholders' equity divided
by two. Return on Common Equity is a similar ratio but uses average common
stockholders' equity.

CAPITAL STRUCTURE RATIOS show how an organization has financed the purchase of
assets and include:

1. Debt to Equity Ratio = Total Liabilities / Total Stockholders' Equity

2. Interest Coverage Ratio = Income Before Income Taxes and Interest Expense)
3. Debt to Asset Ratio = Total Liabilities / Total Assets

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).

debt-to-equity ratio = (Net debt) / (Shareholders equity)

gearing = (Net debt) / (Net debt + Shareholders equity)

Net debt = Interest-bearing debt Excess cash.

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.
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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)

debt cover ratio (long-term view) = (Net debt) / EBITDA

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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.

TYPES OF STABILITY RATIO

Stability Ratios is also called as Long- term Solvency Ratios or Leverage 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 mix of funds provided by owners and lenders and
assure the lenders of the long term funds with regard to:
a) Periodic payment of interest during the period of the loan and
b) Repayments of principal amount on maturity.
Leverage Ratios are of two types:
1) Capital Structure Ratios and
2) Coverage Ratios.
In Capital Structure Ratios there are Six types of Ratios are there which are shown below.
1)
2)
3)
4)
5)
6)

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)

Debt-Service Coverage Ratio (DSCR)

Interest Coverage Ratio
Preference Dividend Coverage Ratio
Fixed Charges Coverage Ratios.

CAPITAL STRUCTURE RATIOS:

The capital structure is how a firm finances its overall operations and growth by using different
sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity
is classified as common stock, preferred stock or retained earnings. Short-term debt such as
working capital requirements is also considered to be part of the capital structure.

BREAKING DOWN 'CAPITAL STRUCTURE'

A firm's capital structure can be a mixture of long-term debt, short-term debt, common equity
and preferred equity. A company's proportion of short- and long-term debt is considered when
analyzing capital structure. When analysts refer to capital structure, they are most likely referring
to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company is.
Usually, a company that is heavily financed by debt has a more aggressive capital structure and
therefore poses greater risk to investors. This risk, however, may be the primary source of the
firm's growth.

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.
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BREAKING DOWN 'CAPITALIZATION STRUCTURE'

While formulating or amending its capitalization structure, a company has to consider the pros
and cons of various sources of capital. For example, equity capital is dilutive, but places less
demands on the financial strength of a company. On the other hand, interest payments on debt
are generally tax-deductible, but debt increases leverage and, hence, the risk profile of the
company.
Although firms in the same business sector will generally have a similar capitalization structure,
it varies widely across different sectors. For example, companies in the technology and
biotechnology sectors have a capital structure that consists almost entirely of equity or common
stock, since they have few tangible assets that can be used as security for debt. On the other
hand, debt forms a significant proportion, often exceeding 50%, of the capitalization structure of
utilities, due to the capital-intensive nature of their business.
Various Types of Capital Structure ratios are:

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

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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.

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:

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BREAKING DOWN 'DEBT RATIO'

The higher this ratio, the more leveraged the company is, implying greater financial risk. At the
same time, leverage is an important tool that companies use to grow, and many businesses find
sustainable uses for debt.
Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and
pipelines having much higher debt ratios than other industries like technology. For example, if a
company has total assets of $100 million and total debt of $30 million, its debt ratio is 30% or
0.30. Is this company in a better financial situation than one with a debt ratio of 40%? The
answer depends on the industry.
A debt ratio of 30% may be too high for an industry with volatile cash flows, in which most
businesses take on little debt. A company with a high debt ratio relative to its peers would
probably find it expensive to borrow and could find itself in a crunch if circumstances change.
The fracking industry, for example, experienced tough times beginning in the summer of 2014,
brought on by high levels of debt and plummeting energy prices.
Conversely, a debt level of 40% 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.
A debt ratio of greater than 100% tells you that a company has more debt than assets.
Meanwhile, a debt ratio of less than 100% indicates that a company has more assets than debt.
Used in conjunction with other measures of financial health, the debt ratio can help investors
determine a company's risk level.
Some sources define the debt ratio as total liabilities divided by total assets. This reflects a
certain ambiguity between the terms "debt" and "liabilities" that depends on the circumstance.
The debt-to-equity ratio, for example, 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), excluding liabilities such as accounts payable, negative goodwill and "other." The debt
ratio is often called the "debt-to-assets ratio."
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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
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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.

3) DEBT TO EQUITY RATIO:

Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage, calculated by
dividing a companys total liabilities by its stockholders' equity. The D/E ratio indicates how
much debt a company is using to finance its assets relative to the amount of value represented in
shareholders equity.
FORMULA:
Debt - Equity Ratio = Total Liabilities / Shareholders' Equity
The result may often be expressed as a number or as a percentage.
This form of D/E may often be referred to as risk or gearing.
2. This ratio can be applied to personal financial statements as well as corporate ones, in which
case it is also known as the Personal Debt/Equity Ratio. Here, equity refers not to the value of
stakeholders shares but rather to the difference between the total value of a corporation or
individuals assets and that corporation or individuals liabilities. The formula for this form of the
D/E ratio, then, can be represented as:
D/E = Total Liabilities / (Total Assets - Total Liabilities)

BREAKING DOWN 'DEBT/EQUITY RATIO'

1. Given that the debt/equity ratio measures a companys debt relative to the total value of its
stock, it is most often used to gauge the extent to which a company is taking on debts as a means
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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.

LIMITATIONS OF 'DEBT/EQUITY RATIO'

Like with most ratios, when using the debt/equity ratio it is very important to consider the
industry in which the company operates. Because different industries rely on different amounts
of capital to operate and use that capital in different ways, a relatively high D/E ratio may be
common in one industry while a relatively low D/E may be common in another. For example,
capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2,
while companies like personal computer manufacturers usually are not particularly capital
intensive and may often have a debt/equity ratio of under 0.5. As such, D/E ratios should only be
used to compare companies when those companies operate within the same industry.
Another important point to consider when assessing D/E ratios is that the Total Liabilities
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 companys liabilities. In some cases,
companies will only incorporate debts (like loans and debt securities) into the liabilities portion
of the formula, while omitting other kinds of liabilities (unearned revenue, etc.). In other cases,
companies may calculate D/E in an even more specific way, including only long-term debts and
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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.

4) DEBT 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 consequently, financial risk. This is a broad ratio that
includes long-term and short-term debt (borrowings maturing within one year), as well as all
assets tangible and intangible.
FORMULA :

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BREAKING DOWN 'TOTAL DEBT TO TOTAL ASSETS'

For example, assume hypothetical company Levered Co. has $40 million in long-term debt, $10
million in short-term debt, and $100 million in total assets. Levered Co. would therefore have a
total debt to total assets ratio of 0.5. On the other hand, if rival LowLevered Co. has $5 million in
long-term debt, $5 million in short-term debt, and $50 million in total assets, its total debt to total
assets ratio would be 0.2.
From the above example, 50% of Levered Co.s assets have been financed by debt, while only
20% of LowLevered Co.s assets were. Levered Co. has a much higher degree of leverage than
LowLevered Co., and therefore a lower degree of financial flexibility.
This is because debt servicing payments have to be made under all circumstances, otherwise the
company would breach debt covenants and run the risk of being forced into bankruptcy by
creditors. While other liabilities such as accounts payable and long-term leases can be negotiated
to some extent, there is very little wiggle room with debt covenants. Therefore, a company
with a high degree of leverage may find it more difficult during a recession than one with low
leverage. It should be noted that total debt measure does not include short-term liabilities like
accounts payable and long-term liabilities such as capital lease and pension plan obligations.
One shortcoming of the total debt to total assets ratio is that it does not provide any indication of
asset quality, since it lumps all tangible and intangible assets together. Continuing from the above
example, assume Levered Co. took on the $40 million of long-term debt to acquire a competitor,
and booked $20 million as goodwill for this acquisition. Lets say the acquisition does not
perform as expected and results in all the goodwill being written off. In this case, the ratio of
total debt to total assets (which amounts to $80 million) would be 0.63.
Like all other ratios, the trend of the total debt to total assets should also be evaluated over time.
This will help assess whether the companys financial risk profile is improving or deteriorating.

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5) CAPITAL GEARING RATIO:

Capital gearing is the degree to which a company acquires assets or to which it funds its ongoing
operations with long- or short-term debt. Capital gearing will differ between companies and
industries,andwilloftenchangeovertime.
Capital gearing is also known as "financial leverage".
FORMULA:
CGA =

(Preference Share Capital + Debentures + Other Borrowed funds)

(Equity Share Capital + Reserves & Surplus Losses)

BREAKING DOWN 'CAPITAL 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 acquisition. When
analyzing a firm undergoing a leveraged buyout, it is important to consider the firm's ability to
service the additional interest payments on an after-tax basis, as well as the likelihood of the firm
paying off the new debt as it matures.

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:
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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

From the above information we can compute proprietary ratio as follows:

= (440,000 / 800,000 ) 100 = 55%

The proprietary ratio is 55%. It means stockholders has contributed 55% of the total tangible
assets. The remaining 45% have been contributed by creditors.

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SIGNIFICANCE AND INTERPRETATION:

The proprietary ratio shows the contribution of stockholders in total capital of the company. A
high proprietary ratio, therefore, indicates a strong financial position of the company and greater
security for creditors. A low ratio indicates that the company is already heavily depending on
debts for its operations. A large portion of debts in the total capital may reduce creditors interest,
increase interest expenses and also the risk of bankruptcy.
Having a very high proprietary ratio does not always mean that the company has an ideal capital
structure. A company with a very high proprietary ratio may not be taking full advantage of debt
financing for its operations that is also not a good sign for the stockholders.

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.

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The following are important coverage ratios:

1) DEBT SERVICE COVERAGE RATIO (DSCR):

In corporate finance, the Debt-Service Coverage Ratio (DSCR) 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, sinking-fund and lease
payments.
In government finance, it is the amount of export earnings needed to meet annual interest and
principal payments on a country's external debts.
In personal finance, it is a ratio used by bank loan officers to determine income property loans.
A DSCR greater than 1 means the entity whether a person, company or government has
sufficient income to pay its current debt obligations. A DSCR less than 1 means it does not.

FORMULA:
DSCR = Net Operating Income / Total Debt Service

BREAKING DOWN 'DEBT-SERVICE COVERAGE RATIO

(DSCR)'
A DSCR of less than 1 means negative cash flow. A DSCR of .95 means that there is only
enough net operating income to cover 95% of annual debt payments. For example, in the context
of personal finance, this would mean that the borrower would have to delve into his or her
personal funds every month to keep the project afloat. In general, lenders frown on a negative
cash flow, but some allow it if the borrower has strong outside income.
Net operating income is a company's revenue minus its operating expenses, not including taxes
and interest payments. It is often considered equivalent to earnings before interest and tax
(EBIT). Some calculations include non-operating income in EBIT, however, which is never the
case for net operating income. As a lender or investor comparing different companies' credit22

worthiness or a manager comparing different years' or quarters' it is important to apply

consistent criteria when calculating DSCR. As a borrower, it is important to realize that lenders
may calculate DSCR in slightly different ways.
Total debt service refers to current debt obligations, meaning any interest, principal, sinking-fund
and lease payments that are due in the coming year. On a balance sheet, this will include shortterm debt and the current portion of long-term debt.
Income taxes complicate DSCR calculations, because interest payments are tax deductible, while
principle repayments are not. A more accurate way to calculate total debt service is therefore:
Interest + (Principle / [1 - Tax Rate])
Lenders will routinely assess a borrower's DSCR before making a loan. If the ratio is less than 1,
the borrower is unable to pay current debt obligations without drawing on outside sources
without, in essence, borrowing more. If it is too close to 1, say 1.1, the entity is vulnerable, and a
minor decline in cash flow could make it unable to service its debt. Lenders may in some cases
require that the borrower maintain a certain minimum DSCR while the loan is outstanding. Some
agreements will consider a borrower who falls below that minimum to be in default.
The minimum DSCR 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. A broad tendency to lend to less-qualified borrowers can in turn affect the
economy's stability, however, as happened leading up to the 2008 financial crisis. Subprime
borrowers were able to obtain credit, especially mortgages, with little scrutiny. When these
borrowers began to default en masse, the financial institutions that had financed them collapsed.

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2) INTEREST COVERAGE RATIO :

3) 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 taxes (EBIT) during a given
period by the amount a company must pay in interest on its debts during the same period.

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)

To provide an example of how to calculate interest coverage ratio, suppose that a

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].
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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)

Generally, an interest coverage ratio of 2.5 is often considered to be a warning sign,

indicating that the company should be careful not to dip further.

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.

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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.

17) PREFERENCE DIVIDEND COVERAGE RATIO:

18)

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:

19) FORMULA :

20)

Preference Dividend Coverage Ratio = Net Profit / Earning after Taxes ( EAT)

21)
22)

Preference dividend liability

Earnings after tax is considered because unlike debt on which interest is charged on the

profit of the firm, the preference dividend is treated as appropriation of profit.

23)

This ratio indicates margin of safety available to the preference shareholders. A higher

ratio is desirable from preference shareholders point of view.

24)

Similarly EQUITY DIVIDEND COVERAGE RATIO can also be calculated taking

( EAT Pref. Dividend) and equity fund figures into consideration.

25) FIXED CHARGES COVERAGE RATIO :

26)

This ratio shows how many times the cash flow before interest and taxes covers all fixed

financing charges. This ratio is more than 1 is considered as safe.

27)

Fixed Charges Coverage Ratio =

EBIT + Depreciation
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28)

Interest + Repayment of loan / 1 tax rate

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)

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