The debt asset ratio measures the extent to which borrowed funds support the firm’s assets. It is defined as:
Debt / Assets:
The numerator of this ratio includes all debt, short term as well as long term, and the denominator of this ratio is the total of all assets (the balance sheet total).
Horizon’s debt asset ratio fro 20X1 is:
212 / 474 = 0.45
This ratio is related to the debt equity ratio as follows:
Debt / Assets = Debt / Equity / 1 + Debt / Equity
Interest Coverage ratio: Also called the times interest earned, the interest coverage ratio is defined as:
Profit before interest and taxes / Interest
Horizon’s interest coverage ratio for 20X1 is:
89 / 21 = 4.23
Note that profit before interest and taxes are used in the numerator of this ratio because the ability of a firm to pay interest is not affected by tax payment, as interest on debt funds is a tax deductible expense. A high interest coverage ratio means that the firm can easily meet its interest burden even if profit before interest and taxes suffer a considerable decline. A low interest coverage ratio may result in financial embarrassment when profit before interest and taxes decline. This ratio is widely used by lenders to assess a firm’s debt capacity. Further, it is a major determinant of bond rating.
Though widely used, this ratio is not a very appropriate measure of interest coverage because the source of interest payment is cash flow before interest and taxes. Not profit before interest and taxes. In view of this, we may use a modified interest coverage ratio:
Profit before interest and taxes + Depreciation / Debt interest
For Horizon Limited, this ratio for 20X1 is: 119 / 21 = 5.67
Fixed Charges Coverage ratio: This ratio shows how many times the cash flow before interest and taxes covers all fixed financing char6egs.’ It is defined as:
Profit before interest and taxes+ Depreciation / Interest + Repayment of loan / 1 – Tax rate
In the denominator of this ratio the repayment of loan is adjusted upwards for the tax factor because the loan repayment amount, unlike interest, is not tax deductible. Horizon’s tax rate has been assumed to be 50 percent.
Horizon’s fixed charges coverage ratio7 for 20X1 is:
119 / 21 + 75/ 0.50 = 0.70
This ratio measures debt servicing ability comprehensively because it considers both the interest and the principal repayment obligations. The ratio may be amplified to include other fixed charges like lease payment and preference dividends.
The fixed charge coverage ratio has to be interpreted with acre because short term loan funds like working capital loans and commercial paper tend to be self renewing in nature and hence do not have to be ordinarily repaid from cash flows generated by operations. Hence, a fixed charge coverage ratio of less than 1 need not be viewed with much concern.
Debt Service overage ratio: Used by financial institutions in India, the debt service coverage ratio is defined as:
Profit after tax + Depreciation + Other non-cash charges + Interest on term loan + Lease rentals / Interest on terms loan + Lease rentals + Repayment of term loan
Financial institutions calculate the average debt service coverage ratio for the period during which the term loan for the project is repayable. Normally, financial institutions regard a debt service coverage ratio of 1.5 to 2.0 as satisfactory.
Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by a firm. These ratios are based on the relationship between the level of activity, represented by sales or cost of goods sold, and levels of various assets. The important turnover ratios are: inventory turnover, average collection period, receivables turnover, fixed assets turnover, and total assets turnover.
Inventory Turnover: The inventory, or stock turnover, measures how fast the inventory is moving through the firm and generating sales. It is defined as:
Cost of goods sold / Average inventory
Horizon’s inventory turnover for 20X1 is:
552 / (105 + 72) / 2 = 6.24
The inventory turnover reflects the efficiency of inventory management. The higher the ratio, the more efficient is the management of inventories and vice versa. However, this may not always be true. A high inventory turnover may be caused by a low level of inventory which may result in frequent stock outs and loss of sales and customer good will.
Notice that as inventories tend to change over the year, we use the average of the inventories at the beginning and the end of the year. In general, averages may be used when a flow figure (cost of goods sold) is related to a stock figure (inventories). —