Financial Leverage Ratios | Debt Ratios | Debt to Total Assets | Debt to Equity | Times Interest Earned Ratios
The debt ratios are often used by financial analysts to measure the relative size of an organisation’s debt load and the firm’s ability to pay off the debt.
The financial ratios are primarily tools for turning the date enclosed in financial statements into information used by managers and executives to better comprehend what is happening in a company.
Financial ratios are highly advantageous indicators of an organisation’s performance as well as financial environment.
Financial ratios are typically used in the process of analysing trends and also comparing the organization’s financial position to other firms.
In few instances, an effective analysis conducted by financial ratios can help to predict the forthcoming bankruptcy or economic failure.
Financial ratios can typically be grouped according to the data they make available.
You Should Remember
Financial ratios can typically be grouped according to the data they make available. However, there are a few important yet frequently used ratios as mentioned below:
Liquidity ratios,
Asset turnover ratios,
Financial leverage ratios,
Profitability ratios,
Dividend policy ratios.
Liquidity Ratios | Current Ratio | Working Capital Ratio | Quick Ratio
Profitability Ratios | Gross Profit Margin | Return On Assets | Return On Equity
Dividend Policy Ratios | Dividend Yield | Payout Ratio | Key Procedural Aspects
Financial Leverage Ratios
The financial leverage ratios, often simply called “leverage” ratios are used to provide a basis for determining how an organisation financed its assets and the ability of the organisation to pay for the non-owner-supplied funds. Unlike liquidity ratios that are associated short-term assets and liabilities, financial leverage ratios measure the extent to which the organisation is using long term debt.
The debt ratios
The debt ratios are often used by financial analysts to measure the relative size of an organisation’s debt load and the firm’s ability to pay off the debt.
The three main debt ratios are:
1. The debt to total assets,
2. Debt to equity; and
3. Times interest earned ratios.
The debt ratio measures the level to which the entire assets of the organisation have been financed using borrowed funds.
When a company’s debt ratios surge considerably, bondholder and lender risk rises for the reason that more creditors compete for the organisation’s Resources if the firm runs into financial anxiety.
Stockholders are also concerned with the sum of debt a business has because bondholders are paid before stockholders.
The finest ratio is determined by many factors, including the category of business and the level of risk lenders and stockholders will accept.
1. Debt to total assets ratio:
The debt ratio is computed as total debt divided by total assets:
2. Debt-to- equity ratio:
The debt to total assets ratio measures the percentage of the organisation’s assets that is funded with debt.
The debt-to-equity ratio is total debt divided by total equity. The calculation for the debt to total assets ratio follows:
Debt ratios are determined by the classification of long-term leases and are determined by the classification of some substances as long-term liability or equity.
3. Times Interest Earned:
The times interest earned ratio is often used to assess an organisation’s ability to service the interest on its debt with operating income from the current period.
The times interest earned ratio is equal to “Earnings Before Interest and Taxes” (EBIT).
The times interest earned ratio specifies how well the organisation’s earnings can cover the interest payments on its debt. The times interest earned ratio also is known as the interest coverage and is computed as follows:
A high times interest earned ratio proposes that the organisation will have sufficient operating income to shield its interest expense. A low ratio indicates that the organisation may have inadequate operating income to pay interest as it becomes due. As a result, the business might call for to liquidating assets, or raising new debt or equity funds to pay the interest due.
Limitations of Financial Ratios
Those who practice financial ratio analysis for decision-making processes must also be conscious of its limitations. Indeed, there are several limitations that influence in contrast to their effectiveness. Those are as follows;
1. The financial analysis cannot be a factual guide to organisation’s performance as it does not help the financial analyst drive deep into operational details.
For example, if an organisation does not keep up a sound depreciation policy and announces huge profits, high profitability ratios would basically be deceptive.
2. The values of the current assets as well as amount produced change frequently which may create misrepresentations in accounting measures of performance and financial situation.
3. The reliability of the standards against which the ratios are seen, is frequently uncertain. Except the norm is consistent, any implication drawn on the basis of ratios may be deceptive.
Hence, those who deal with the ratios must supplement the financial ratio analysis with substitute implements in order to test its trustworthiness.
Concept & Definition of Accounting ?
Characteristics of Accounting ?
Key Differences Between Accounting & Finance ?
basis of accounting: Cash Basis & Accrual Basis ?
Fundamental Financial Accounting Assumptions, Principles & Conventions
Core Steps in Accounting Cycle | During & End of Accounting Period
4 Financial Statements | Balance Sheet | Retained Earnings | Cash Flows
The Balanced Scorecard | Comprehensive Knowledge | Measures | Perspectives
Capital Budgeting | Definitions | Features | Process | FIVE Stages
Capital Budgeting Decisions | Criteria | Substitute Directions | Implications
Liquidity Ratios | Current Ratio | Working Capital Ratio | Quick Ratio
Profitability Ratios | Gross Profit Margin | Return On Assets | Return On Equity
Dividend Policy Ratios | Dividend Yield | Payout Ratio | Key Procedural Aspects
