Financial Ratios
Definition
Business Finance involves a number of different metrics. Beta is considered to be one of the most important concepts in business finance. As a matter of fact, Beta is defined as a measure of volatility that a business faces with respect to other factors. Furthermore, it encapsulates the systematic risk of an underlying security or portfolio. The main usage of Debt Beta is under Capital Asset Pricing Model. The CAPM model signifies and describes the existing relationship between systematic risk as well as expected return for assets. Depending on the capital structure of the company, there are two broad categories of beta: levered beta and unlevered beta.
On one hand, it can be seen that Levered Beta measures the market risk that the company is exposed to. Since it captures the elements involved in the market, it is also referred to as equity beta. On the contrary, as far as unlevered beta is concerned, it does not factor in debt. This is to mainly eradicate the risk that exists because of company’s assets.
Speaking of debt beta, it is assumed to be zero when calculating levered beta because debt is considered to be risk-free, unlike equity. Where debt beta is not considered to be zero, then it is included in the calculation. It reflects the fact that there is an inherent systematic risk of the debt which needs to be factored in.
Debt beta is used in case of calculating beta of the firm. It is used in the following formula:
Asset Beta = Equity Beta / (1+ [(1 – Applicable Tax Rate) (ratio of debt to equity)]
Unlevered Beta = Asset Beta (in the case where the company assumes no leverage)
Levered Beta = Levered Beta / (1 + [(1 – Tax Rate) (debt/equity)]
Explanation
A company’s gearing ratio is directly proportional to the beta calculation. Factually, both levered, and unlevered beta are representative of the stock volatility in conjunction with the overall market. Regardless, it can be analyzed that levered beta implies that as the company continues to take on more and more debt, it’s market volatility considerably increases. This is primarily because of the fact that it reflects the risk that the business has taken on by stacking up more debt.
Despite the fact that debt beta (or consider it insignificant) is not always used by companies, but it is still considered a very important metric. This is more applicable in the case of highly leveraged companies. This implies that debt beta and its interpretation is really important for organizations because it helps them to analyze their risk profiles accordingly.
Advantages
Calculation of debt beta is considered to be important for companies on a number of grounds. The main advantages include:
- Calculation of debt beta is considered an important phenomenon because it works out in favor of almost all the stakeholders, primarily the investors as well as the creditors. This is because it encapsulates why all the inherent risks included with debt and their subsequent correlation with market volatility.
- The capital structure of the company also provides some useful insights, which help the company to make strategic risk decisions in the future.
- Calculation of debt beta helps companies decide on the perfect capital structure, and how they should ideally make changes in their capital structure to align themselves with their risk policy.
Disadvantages
Given the fact that debt beta is considered to be a highly important metric, yet there are a couple of pitfalls of debt beta that need to be accounted for. They are as follows:
- Calculation of Debt Beta is considered to be a complex task. In most cases, the chances of error are quite substantial, and hence, this is something that needs to be incorporated in the overall analysis.
- Calculation of Debt Beta is considered redundant primarily because of the fact that it is assumed to be risk-free. The results might be skewed from the perspective of the company depending on how lowly or highly geared the company is.
- In the case where debt is customized, and there are numerous different stakes involved, debt beta cannot be entirely resourceful. This is because risk in itself can never be accurately encapsulated in real terms. In that case, Debt Beta does not prove to be as effective.
Therefore, it can be seen that a debt beta is an important tool that forms the basis for a variety of different transactions within the company. In this regard, it imperative to consider the fact that even if it fails to accurately incorporate the exact results, it still is a resourceful metric.
Financial Accounting, Financial Ratios
The basic accounting equation broadly includes three components: assets, liabilities, and equity. These three components formulate the balance sheet of the company and using these components, and the balance sheet is subsequently prepared. However, within these categories, there are several different subcategories that are included.
For example, assets include Current Assets and Non-Current Assets, and within those categories, there are several different varieties of assets that are included in the balance sheet.
However, as far as liabilities are concerned, they are fairly more complex as compared to assets because they include a variety of different components that define a variety of different tasks.
Total Debts and Total Liabilities are two different things. Regardless of the fact that they both have the same accounting treatment and are representative of the cash outflows of the company (or, in other words, the amount that the company owes), yet they are not the same.
In simple terms, total liabilities are a parent category, and total debt is a subcategory. Calculation of total liabilities includes debt as a component, but it is not the other way around.
As far as total liabilities are concerned, they are defined as the amounts that are due by the company to their suppliers or other various creditors. They are broadly categorized into two main categories, Current Liabilities and Non-Current Liabilities.
Current Liabilities mainly include the payments that the company has to make over the period of 1 year. On the other hand, as far as Non-Current Liabilities are concerned, they are relatively long-term in nature and need to be settled after a period of more than 12 months.
Some of the major examples of liabilities include payments that need to be made to the suppliers, accrued utility bills, as well as long-term contractual loans that the company has taken on. Depending on the timeline of settlement, they are subsequently categorized as Current or Non-Current Liabilities.
A very major component of total liabilities is considered to be debt. Debt can be defined as an amount that the company has undertaken from another organization (in most cases, this organization is a bank) for a specific purpose.
This purpose may vary from firm to firm. It can be for expansionary purposes, or it can also be for other purposes like enabling running finance for the company. It is mostly long-term in nature, but this amount is representative of something that is owned by the company. It is mostly classified as a long-term, non-current debt.
Debt is mostly interest-bearing, unlike other liabilities of the company. Since this is a significant amount that is taken on by the company from an external source, it comes with a financial cost. This financial cost is termed as the interest.
Depending on the agreement between the debt holder and the bank, repayment of the debt can vary from situation to situation. However, generally, the debt is repaid in the form of installments and an interest charge every year.
For the particular year where the installment and the interest charge is supposed to be repaid, the part of the debt is classified as a Current Liability. The remaining portion of the debt, which is due after a period of 12 months, is still categorized as Non-Current Liability.
Therefore, it can be seen that both debt and total liabilities of the company are similar in nature. They have the same accounting treatment and are represented in the same manner on the Balance Sheet. However, total debt is considered to be a part of total liabilities.
In other words, total liabilities include a number of different accruals for the firm, including total debt. Hence, in simple terminology, debt is considered to be a part of total liabilities, but they are not the same thing.
However, they are classified separately on the Balance Sheet because of the fact that external stakeholders (particularly investors and shareholders) look at both liabilities as well as the total debt position of the business.
This helps them to calculate the leveraging position of the company, which helps them to make some major decisions regarding the company. However, they are looked at individually, as well as from an aggregated perspective. Therefore, it can be seen that total debt is considered to be a subcategory of total liabilities.
Debt is considered to be a part of liabilities, but there are several other components that are included as liabilities of the company. However, total debt, more often than not, is considered to be one of the most significant components of total liabilities.
Financial Ratios
Definition:
Net Operating Assets can be defined as the assets within a business that is related to the operations of the business. It is simply defined as the difference between the operating assets of the company, and the operating liabilities of the company.
Net Operating Assets are basically the representation of how many assets, and liabilities the business has at a given point in time, that are relevant to the operating activities of the business.
It is important to identify net operating assets, because it discretely segregates the amount that the business has invested in its core operating activities, versus its other activities, which include financial activities of the organization as well.
Net Operating Assets basically involves calculating the number of assets and liabilities that are the business is operating with.
It mainly comprises balance sheet restructuring in order to segregate the operating assets from the non-operating assets. However, net operating assets can be calculated in two broader ways:
Operating Approach
Firstly, Net Operating Assets can be calculated using the Operating Approach. As far as the operating approach is concerned, it comprises of calculating net operating assets using the following formula:
Net Operating Assets = Operating Assets – Operating Liabilities
However, in order to calculate net operating assets using this approach, the balance sheet must be reformatted in order to accurately calculate operating assets and operating liabilities in an accurate manner. In this regard, operating assets are calculated using the following formula:
Operating Assets = Total Assets – Excess Cash (and Cash Equivalents) – Financial Assets (including the investments carried out by the company)
In the same manner, operating liabilities are also calculated using the following formula:
Operating Liabilities = Accounts Payable + Deferred Operating Expenses (Accruals) + Deferred Taxes on Operating Income + Reserves maintained for Operating Expenses
Financing Approach
Alternatively, it can be seen that the financing approach can also be used to calculate the Net Operating Assets. Net Operating Assets calculated using the financing approach have the following formula:
Net Operating Assets = Equity + Short-term and Long-Term Non-Operating Debts (Non-Current Operating Assets) – Financial Assets and investments – Excess cash and cash equivalents
Using the financing approach, it can be seen that the amount of net operating assets is calculated as the net amount of interest-bearing debts.
Usages of Net Operating Assets
Net Operating Assets is considered to be a very useful metric for the organization since it has a number of advantages for the decision-makers of the company.
It is used for the purposes of comparing the net profit of the business with other relevant business models. It shows the net income (or net operating income) that the company has earned, in comparison to the total net operating assets it has.
Given the fact that it mainly ignores the financial benefits that are extrapolated as a result of interest-bearing expenses, the impact of leverage is minimized from the returns.
Hence, this represents the core profits that are generated by the company as a result of their operations, with respect to the operating assets that they have.
In the same manner, Net Operating Assets also stands to be a very viable basis to calculate other subsequent metrics, including Discounted Cash Flows, Free Cash Flows as well as Discounted Operating Earnings. These metrics are considered valuable in terms of estimating the value of the company.
However, the greatest use of Net Operating Assets is perhaps the fact that net operating assets are considered to be resourceful is because of the fact it helps to show the operating threshold of the company, in terms of the investment it has made in the existing operations within the company.
Limitations of Net Operating Assets
Where on one hand, net operating assets are representative of the extent to which operations are properly managed, yet it can be seen that the fact that they do not include any analysis pertaining to the financial leverage of the organization.
For example, an organization might have higher net operating assets, but its financial asset management might not be that efficient. In this case, relying solely on this metric might be risky from the perspective of the organization.
In the same manner, Net Operating Assets are calculated using the book value of the assets and the liabilities that are mentioned on the balance sheet.
However, this might not be representative of the true and the fair value of the net operating assets, since these figures in the balance sheet might not be aligned with the existing market values for these respective assets and liabilities.
Therefore, it might not a true and fair estimate if used in comparison with other organizations. It is only resourceful if it is analyzed over a course of time, for a single company only.
Financial Ratios
Definition:
Price to Earnings Ratio is a very important metric that is used by investors in order to gauge the viability of a particular stock. This particular stock draws a comparison between the price of the particular share and the earnings that the company has reported over the course of time.
This ratio is basically a representation regarding what the market is ready to pay current for the listed stock based on its earnings. These earnings can be both, past and forward PE.
In the case where past earnings are utilized to calculate the PE Ratio, it is referred to as a trailing PE Ratio. On the other hand, if the future estimates and approximations are used in order to calculate the future earnings, it is referred to as a forward PE Ratio.
From the investors’ perspective, it can be seen that investors mostly require and go for shares that have a higher PE Ratio.
This is mainly because of the fact that it shows that the given stock or share has the potential to earn a substantial amount of money in comparison to other stocks with relatively lower PE Ratios.
Hence, this particular metric is highly resourceful because it helps to draw a comparison between different stocks pertaining to their ability to generate profits.
PE Ratios are mostly positive. Positive PE Ratios are indicative of the fact that the company is making profits, and is sustaining itself.
However, in the case where the company is making a loss or is unable to make decent profits, it can be seen that PE Ratio can also be negative.
It must be noted that there are very cases where companies report negative PE Ratios because it is not beneficial for them to report them otherwise.
Price to Earnings Ratio is a comparison of the existing price of the stock, relative to the overall earnings it is generating. Therefore, it is calculated using the following formula:
PE Ratio = (Price of the stock) / (Total Earnings of the company or Earnings per Share)
Reasons for negative P/E Ratio:
Despite the fact that in most cases, companies have positive PE Ratios, it can be seen that there are a few instances where the company might end up having negative PE Ratios.
It is mainly because of the fact that the company has reported negative earnings over the recent past, because of which the PE Ratio turns out to be negative. The main reasons for a negative PE Ratio are as following:
- Company incurring a loss over the course of time – this means that the company has not reported profits over the recent past, because of which the denominator is negative. This would automatically make the PE Ratio negative.
- New projects: In the case of new projects, companies often have negative PE Ratios because they are in the initial phases, and they have not begun generating revenues as yet. This is often the case for newly established businesses, which are incurring initial setup costs as a result of new projects being set up.
- In the same manner, it can also be seen that negative PE Ratios often occur because of unprecedented circumstances and situations. A company suffering an unprecedented loss, or an uncalled-for expense might be the reason behind the negative PE Ratio.
Implications for Negative PE Ratio:
A negative PE Ratio can often be a cause of an alarm for investors. It might hint that the company is no longer doing well, and might declare bankruptcy in the coming future.
However, it must be seen that a negative PE Ratio that persists across the company’s balance sheet is often a cause of concern for the investors.
On the other hand, if the negative PE Ratio is temporary, and occurs as a one-off incident, is not always necessarily a bad thing. Here are a few reasons why a negative PE Ratio is not always bad:
- A negative PE Ratio that occurs because of a one-off incident, like an unprecedented loss or litigation will reduce the earnings for that particular year only. In this case, it is better to realize the fact that negative PE Ratios for that particular year can be relevant to that particular year only. Therefore, it might helpful for investors to consider past (trailing) PE Ratios to get a better idea about the company.
- Negative PE Ratios that happen because of the investment in numerous different resources and projects might mean that there are better growth prospects for the company in the future, which are currently unaccounted for. Hence, negative PE Ratios in individuality might not be an accurate representation of the organization’s position.
Financial Ratios
Definition and Explanation
Gearing Ratio is defined as the financial ratio that draws a comparison between the owner’s equity in the company, debt, or the number of funds that are borrowed by the company. Gearing can be defined as a metric that measures the company’s financial leverage.
Financial leverage basically shows the degree to which the operations and the overall company if funded with equity financing versus debt financing.
Therefore, to summarize gearing ratios can be defined as a group of financial metrics that are used to compare shareholders’ equity to the existing company’s amount of debt that the company has drawn.
This is considered to be a very important metric to gauge the company’s leverage, as well as financial stability. They are compared with the other gearing ratios that exist in the company in order to get an idea about the existing industry average.
Gearing Ratios are metrics, and in order to calculate gearing ratios, different aspects of the company are included.
The gearing ratios are defined as different ratios that measure different things about the particular organization. Therefore, they are categorized as the following types:
Times Interest Earned = (Earnings before Interest and Tax) / Total Interest
(Times Interest Earned Ratio is a representation of the total earnings of the company, as a percentage of the interest that the company has paid. This helps to show how much the company has earned, against the interest and the financial cost that they had to bear as a result. )
Equity Ratio = Equity / Assets
(Equity Ratio is a representation of the total equity that the company has, as a percentage of the total assets. This shows the number of assets that the company has, the percentage of those assets, which are backed by the equity of the company.)
Debt Ratio = Total Debt / Total Assets
(Similar to equity ratio, the debt ratio is considered to be a representation of the total assets that the company has, and out of those assets, how much are attributable to the debt that the company has drawn over the recent years)
Is Gearing Ratio similar to the Debt-Equity Ratio?
The debt-to-Equity Ratio describes the total debt that is drawn by the company against the total equity that the owners of the company have raised. It directly shows the percentage of the company that is leveraged by debt.
In other words, it shows the amount of debt that is drawn by the company against every $1 of equity raised by the company. It is calculated using the following formula:
Debt-to-equity Ratio = Total Debt / Total Equity
Often this particular ratio is referred to as the gearing ratio. It is mainly because of the fact that it tells about the extent to which the company is reliant on debt, versus the equity that they have raised over the period of time. Therefore, it gives a very useful insight into the leverage position of the company.
Hence, it would not be considered incorrect to say that the debt-to-equity ratio is considered to be a category of the gearing ratio. However, gearing can also be measured using other several metrics and ratios, like the ones mentioned above.
How can Gearing Ratio be improved?
Gearing Ratio is considered to be one of the very important metrics of the company. There is no specific ‘ideal’ gearing ratio for the company. It depends from company to company.
As a matter of fact, the optimal debt-to-equity structure is a factor of a multitude of things, including the weighted average cost of capital of the firm, as well as the cost of equity and cost of debt that the company has.
However, there are costs and benefits associated with being highly geared and lowly geared. Depending on the situation that suits the company best, this can be subsequently prescribed.
In the case where the company is lowly geared, it means that the company has a significant amount of resources obtained from equity finances. In order to increase the gearing of the company, they are supposed to get debt.
They can either buy back shares from the existing shareholders (and issue debt against this repurchase), or they can simply take on more debt – in the case where they are looking to finance a particular project.
In the same manner, in the case where the company is highly geared and wants to reduce the gearing, the company has an option to issue more shares, and pay back the debt. In most cases, servicing the debt, and paying back the liabilities automatically reduces the liability of the company.
Financial Ratios
Introduction
The fast-paced business environment in the modern-day and age poses an increasingly challenging dynamic for investors. This is primarily because of the fact that there are numerous different options that investors have to choose from, and therefore, they ideally look for options that are likely best suited to their investment profile and taste.
In this regard, it is also important to note the fact that investors today are supposed to ensure that they are able to carry out a stringent study of the organization they plan to invest in so that they are able to knowingly invest from the options they have available.
In this regard, investor ratios tend to be highly resourceful for investors, because they are able to impart some extremely valuable information about the organization.
Definition
Investor Ratios can simply be defined as ratios that the investors use in order to evaluate the ability of the company to maintain profitability and continue generating positive returns against their investment.
Investor ratios are considered to be extremely important when making investment decisions because of the fact that they provide some useful and valuable insights about the company in context to other companies, or other existing investment options.
Investor Ratios can be categorized into numerous different categories, depending on the different existing ratios that exist.
Types of Investor Ratios
There are a number of investor ratios, which prove to be critical for investors. They are mentioned below:
Earnings per Share
Earnings per Share is a numeric representation of the earnings that the particular organization earned over the course of time. It is calculated using the following formula:
Earnings per Share = Total Earnings / Outstanding Shares of the company
This particular ratio shows the company’s ability to generate profit. From an investor perspective, the higher the EPS (Earning per Share), the better the investment prospect.
This ratio is also compared over time. If over the course of time, the company reports higher and higher earnings per share, it means that the future prospects of the company look widely positive.
Price to Earnings Ratio
P/E Ratio (Price to Earnings Ratio) is a comparison of the amount that the company earns, with the price of the particular share. This relationship between the share price, and the earnings that are respectively earned out of that investment are indicative of the value of the company in the existing capital market.
This ratio also tends to be important for the investors because it gives them an idea about what to expect on the fronts of the risk-reward scheme. P/E Ratio of the company is calculated using the following formula:
P/E Ratio = Share Price / Earnings per share
Hence, it can be seen that this particular ratio incorporates both, the share price, and the number of shares that are issued by the organization.
Dividend Cover
Dividend Cover can be defined as the financial ratio that takes into account the number of times the company can pay dividends to the shareholders. This is done by comparing the net income of the company with the dividend that is paid.
Hence, it encapsulates the number of times the company can pay dividends from the net income that is generated by the company. Therefore, it is calculated using the following formula:
Dividend Cover = (Net Income) / (Dividends declared or Paid)
Alternatively, dividend cover can also be calculated by comparing the EPS and the declared dividend by the company for the ordinary shareholders. In this particular scenario, the formula for dividend cover is as follows:
Dividend Cover = EPS / (Dividend Declared per ordinary share)
Dividend Yield
Dividend Yield can be described as the financial ratio that provides a direct measure that is generated from a return of investments that are made in the shares of the company. This is calculated by comparing the dividend per market share to the existing market price per share.
This particular metric is also frequently used by investors because it helps them compare and subsequently assess the relative benefits of existing investment opportunities in the market. In the same manner, it can also be seen that this helps to calculate the return on investment, which investors can expect to generate.
Therefore, this is calculated using the following formula:
Dividend Yield = (Dividend per Share) / (Share Price)
The dividend yield is basically a metric that shows the return that can be generated as a result of the investment in the particular company. Hence, this tends to be one of the main factors which investors incorporate, so that they can choose stocks that have a higher dividend yield in comparison.
