Archive for September, 2008

Debt to Equity

The debt-to-equity ratio can be computed with the following formula, using figures from your balance sheet:

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The ratio of debt-to-owner’s equity or net worth indicates the degree of financial leverage that you’re using to enhance your return. A rising debt-to-equity ratio may signal that further increases in debt caused by purchases of inventory or fixed assets should be restrained.

Improving this ratio involves either paying off debt or increasing the amount of earnings retained in the business until after the balance sheet date. For instance, can expenses be deferred beyond the balance sheet date to increase your retained earnings? What about bonuses? Delaying any planned bonus expense serves to increase your retained earnings. As another example, you might think about repaying revolving debt (such as a line of credit) before the balance sheet date and borrowing again after the balance sheet date.

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Measures of long-term credit risk

The final group of ratios is designed to help you measure the degree of financial risk that your business faces. “Financial risk,” in this context, means the extent to which you have debt obligations that must be met, regardless of your cash flow. By looking at these ratios, you can assess your level of debt and decide whether this level is appropriate for your company. Commonly used solvency ratios are:

  • debt to equity
  • debt to assets
  • coverage of fixed costs
  • interest coverage

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Coverage of Fixed Charges

Coverage of fixed charges is also sometimes called “times fixed charges earned.”

It can be computed by taking your net income, before taxes and fixed charges (debt repayment, long-term leases, preferred stock dividends etc.), and dividing by the amount of fixed charges. The resulting number shows your ability to meet your fixed obligations of all types — the higher the number, the better.

Obviously, an inability to meet any fixed obligation of the business threatens your business’s well-being. Many working capital loan agreements will specify that you must maintain this ratio at a specified level, so that the lender has some assurance that you’ll continue to be able to make your payments.
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Debt to Assets

This ratio measures the percentage of a business’s assets that are financed with debt, and can be calculated using the following formula:

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This ratio measures the percentage of assets financed by creditors, compared to the percentage that has been financed by the business owners. Historically, a debt-to-asset ratio of no more than 50 percent has been considered prudent. A higher ratio indicates a possible overuse of leverage, and it may indicate potential problems meeting the debt payments.

Improving this ratio means taking steps to either increase the value of your assets, or to pay off debt. For example, you might explore whether inventory or other assets can be given a higher value. If you go the route of paying off debt, you’ll also improve your current ratio and debt-to-equity ratio.

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Interest Coverage

Interest coverage is also sometimes known as the “times interest earned ratio.” It is very similar to the “times fixed charges earned” ratio but focuses more narrowly on the interest portion of your debt payments.

To calculate this ratio, you can use the following formula:

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By comparing the ratio of operating income to interest expense, you measure how many times your interest obligations are covered by earnings from operations. The higher the ratio, the bigger your cushion and the more able the business is to meet interest payments. If this ratio is declining over time, it’s a clear indication that your financial risk is increasing.

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Measures of profitability

You can use another set of ratios to assess the profitability of your business and changes in its profit performance. These ratios are probably the most important indicators of your business’s financial success. Investors (including yourself, as business owner) will be interested in these ratios insofar as they demonstrate the performance and growth potential of the business:

  • gross profit margin ratio
  • net profit margin or net profit percentage
  • operating profit percentage
  • return on assets
  • return on equity

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Gross Profit Margin Ratio

Your gross profit margin can be calculated with the following formula, using figures taken from your income statement:

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Recall that gross profit is the amount of sales dollars remaining after the cost of goods sold has been deducted.

If your gross profit margin is declining over time, it may mean that your inventory management needs to be improved, or that your selling prices are not rising as fast as the costs of the goods you sell. If you are a manufacturer, it may mean that your costs of production are rising faster than your prices, and adjustments on either side (or both) are necessary.

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Net Profit Margin

Your net profit margin shows you the bottom line: how much of each sales dollar is ultimately available for you, the owner, to draw out of the business or to receive as dividends. It’s probably the figure you are most accustomed to looking at. This ratio takes into account all your expenses, including income taxes and interest.

If your net income is $500,000 and sales are $2,000,000, your profit margin is 25 percent

You should have some idea of the range within which you expect your profit margin to be, which will be determined in large part by industry standards. If you fail to meet your target, it could mean that you’ve set an unrealistic goal, or it could mean that you’re doing something wrong. (However, the ratio itself will not point to what you may be doing wrong. Looking at your gross margin or operating margin is a better way to get a fix on the problem.)

Even if you meet your goal, you should always keep an eye on your profit margin. If it should decline, for example, it may indicate that you need to take a look at whether your costs are getting too high.

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Operating Profit Percentage

The operating profit percentage can be calculated using the following formula, with figures taken from your income statement:

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This ratio is designed to give you an accurate idea of how much money you’re making on your primary business operations. It shows the percentage of each sales dollar remaining after all normal costs of operations. By looking at this ratio over time, you can get a fix on whether your overall costs are trending up or down.

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Return on Assets

Return on assets is the ratio of net income to total assets. It is basically a measure of how well your business is using its assets to produce more income. It can be viewed as a combination of two other ratios, net profit margin (ratio of net income to sales) and asset turnover (ratio of sales to total assets):

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A high return on assets can be attributable to a high profit margin, a rapid turnover of assets, or a combination of both.

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