Thursday, November 9, 2006

Financial ratios

Read an article on Financial ratios by CRISIL which has to say the following:


The overall financial health of a company can be captured by eight primary financial parameters: capital structure, interest coverage, debt service coverage, net worth, profitability margin, return on capital employed, net cash accrual to debt ratio and current ratio.  Other financial ratios such as asset turnover ratio, inventory turnover ratio, dividend pay out, debtor levels, and return on net worth are also important but the eight parameters are sufficient for a primary definition of a company’s overall financial risk profile.


A company’s capital structure commonly referred to as gearing, leverage, or debt/equity ratio, reflects the extent of borrowed funds in the company’s funding mix. The equity component in a company’s capital employed has no fixed repayment obligations; returns to investors depend on the profits made by the company. Debt, on the other hand, carries specified contractual obligations of interest and principal. These will necessarily have to be honoured, in full, and on time, irrespective of the volatility witnessed in the business. A company’s capital structure is invariably a function of the strategy its management adopts.


Interest coverage represents the extent of cushion that a company has in meeting its interest obligations from surpluses generated from its operations. The interest coverage ratio links a company’s financial charges to its ability to service them from cash generated from operations.


The Debt service coverage ratio (DSCR) indicates a company’s ability to service its debt obligations, both principal and interest, from earnings generated from its  operations. The textbook definition of DSCR assumes that debt repayment gets higher priority over working capital expansion. In practice, however, the priority is often reversed: working capital funding takes priority over other payments. Low DSCRs may not necessarily have an unfavourable impact on ratings; the company’s ability to replace its existing debt with fresh funds may act as a favourable factor.


A company’s net worth represents shareholders’ capital that does not have fixed repayment or servicing obligations. It therefore provides a cushion against adverse business conditions.


I’m getting weary after studying four ratios. So I’ll come back with the other four (profitability margin, return on capital employed, net cash accrual to debt ratio and current ratio.) ratios later. Phew.



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