Any business that wants to scale and grow needs financial stability. The financial health of any business entity is very critical to determine the scaling potential. Any company struggling to meet its day-to-day expenses cannot dream of becoming one of the top 100 Fortune companies.
Any investor, creditor, or banker will only invest in your business if you can prove that you can learn and run. Poor financial metrics, negative operating balances, and negative cash flows are the biggest red flags for any business. If any business has such financial results, it is obvious that the entity has poor financial management.
What can be done to bring your business entity on the right track?
You must improve your business’s performance and financial health. This can be done by increasing revenues, decreasing expenses, capitalizing on more profitable opportunities, and more actions.
But the question is still there. How can you know about the financial health of the company? Merely net profit or cash in your hand doesn’t determine how well your business is doing.
There are numerous financial analyses used in financial management. But, ratio analysis is the most useful analysis. It enables the business to understand the financial health of the company by comparing it with previous years.
Besides, the historical and comparative perspective of different financial aspects is also highlighted. In other words, we can say that ratio analysis gives a blueprint of the weaknesses and strengths of any business.
Ratio Analysis In Financial Management
Ratio analysis is a very important business valuation analysis. Investors and creditors can determine the best option among different available choices. The ratio analysis provides a base for comparing the market position and financial health of different companies.
Comprehensive ratio analysis to depict the financial health of an entity is based on 5 key components. The 5 key areas focused by a reliable analysis are following:
Revenues of a company
It encompasses revenue growth, revenue per employee, and other revenue-related metrics.
Profitability is very critical to the existence of any business entity. To analyze the future prospects of any business entity, it must have consistently growing profits. Gross profit, net profit, and operating profits are some of the metrics.
A successful business achieves maximum efficiency with the limited resources. Operational efficiency is a measure of a firm’s efficiency in using resources to get output. The most common operational efficiency measures include inventory turnover ratios, asset turnover, account receivable turnover, etc.
Capital Efficiency and Solvency
A business must exist in the long term. The solvency or capital efficiency of a business is measured by the debt-paying ability. Capital efficiency and solvency ratios are the prime concern of any creditor or investor before making an investment decision. Debt to equity ratio, return on equity, etc., assess the solvency and capital efficiency.
The fifth key area that must be assessed as a part of comprehensive financial analysis is Liquidity. Liquidity measures the company’s ability to meet its short-term obligations and debt. Short-term refers to the items related to the current financial year. The most common liquidity ratios include current ratios and coverage ratios.
Expenditure Coverage Ratios
There are two types of expenses: Capital expenses and operating expenses.
Capital expenses are related to the financing and investing activities of a business. These are usually spread over several years.
Operating expenses are expenditures related to the current financial year in most cases. These are expenditures incurred for the day-to-day operations of a business.
Expenditure coverage ratios, commonly known as coverage ratios, are the best measure of assessing the company’s expenditure paying ability. The difference between coverage ratios and expenditure coverage ratio is that coverage ratios are related to capital expenditure coverage.
However, expenditure coverage ratios must encompass operating as well as capital expenditures. So, the expenditure coverage ratios include something more than just coverage ratios.
We can define expenditure coverage ratios as,
Expenditure coverage ratios are part of a business’s financial valuation analysis. It measures how well a company can cover its expenditures, capital or operate, by using its assets and cash flows.
Types Of Expenditure Coverage Ratios
Based on the definition, we have identified the following ratios under the scope of expenditure coverage ratios.
- Coverage Ratios
- Liquidity Ratios
Coverage ratios assess the company’s ability to meet the financial obligations, specifically the debt-paying ability. It measures how well a company’s assets or cash can cover its debt obligations or expenditures. The minimum standard for coverage ratio is 1:1.
Following are some of the coverage ratios:
Interest Coverage Ratio
The interest coverage ratio is a capital expenditure coverage ratio that assesses a business’s ability to pay the interest expense on its debt. This ratio does not encompass the company’s ability to pay back the debt itself.
The interest coverage ratio must be at least 1:1. If the ratio is above the minimum standard, for instance, 2:1, it represents better financial health.
The formula for interest coverage ratio is as follow:
Interest Coverage Ratio= Operating Income / Interest Expense
Debt-Service Coverage Ratio
The debt-service coverage ratio measures the company’s ability to meet the debt obligations by using the operating income. The debt obligation includes principal debt and interest expense. This ratio is most commonly calculated at the time of applying for a bank loan.
The minimum standard for DSCR is also 1:1, but a higher ratio of 2:1 or above is better.
The formula for debt-service coverage ratio is as follow:
Debt-Service Coverage Ratio= Operating Income / Debt Service
Asset Coverage Ratio
The asset coverage ratio assesses that how well a company’s assets cover the debt obligations. It measures the company’s ability to pay the debt obligation by selling assets and after settling liabilities. The asset coverage ratio is more like a solvency ratio. It cannot be counted under the expenditure coverage ratio. However, the margin exists for the capital expenditure coverage ratio.
The formula for asset coverage ratio is as follow:
Asset Coverage Ratio = (Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)/Total Debt Obligation
Cash Coverage Ratio
This coverage ratio relates to the business’s ability to pay the annual interest expenses. It measures that how well the company’s available cash can be used to pay the annual interest expense.
The ratio of 1:1 or above is considered the better measure.
The formula for cash coverage ratio is:
Cash Coverage Ratio= Total Cash / Interest Expense
Liquidity ratios measure the company’s ability to pay its short-term debt obligations and current liabilities using current assets and cash. Liquidity ratios come under the scope of operating expenditure coverage ratios.
Current liabilities of any business entity consist of short-term debt, account payables, outstanding expenses, outstanding taxes & insurances, and outstanding obligations. Therefore, the ratio measures how well the company’s cash equivalents can pay the liabilities.
Following liquidity ratios come under the scope of expenditure-coverage ratios :
The current ratio measures the company’s short-term debt-paying ability. The ratio of 1:1 is the minimum standard. A higher ratio means a company is better able to cover its short-term obligations by using current assets.
However, too much high ratio is not encouraged. It depicts that the company’s capital has been restricted, hence, limiting profit-making ability.
The formula for the current ratio is as follow:
Current Ratio= Current Assets / Current Liabilities
The quick ratio is a more strict measure of a firm’s ability to cover its outstanding expenditures and short-term obligation. For calculation of quick ratio, inventory is excluded from the current assets.
The reason behind it is that this item might take some time to be converted into cash. Therefore, including these items might overstate the company’s ability to immediately settle the outstanding expenses.
The formula for quick ratio is as follow:
Quick Ratio= Cash + Account Receivables + Marketable Securities / Current Liabilities
The cash ratio is the most accurate measure of how well a company can meet its short-term obligations by using cash and cash equivalents. The ratio must be higher than 1:1. In this ratio, account receivables are also deducted from the scope. Because account receivables might also need time to be collected.
The formula for cash ratio is as follow:
Quick Ratio= Cash + Marketable Securities / Current Liabilities
Why Does Expenditure Coverage Ratios Matter?
Why does the expenditure coverage ratios of a company are important?
These ratios are most widely used by the external as well as internal stakeholders of any business.
As for internal stakeholders are concerned, expenditure coverage ratios help the company assess how well they can meet their long-term and short-term expenses. By assessing the results, the company can decide about investing in new opportunities.
For instance, if the company’s quick ratio is 4:1. It means there is a lot of excess cash and equivalents. This is affecting the company’s operating efficiency negatively. Therefore, the company must take action to invest excessive cash to make full use of capital.
On the other hand, external stakeholders mostly employ the coverage ratios. The coverage ratios help the investors and creditors to decide about the attractiveness of an investment. If a company is well-equipped to meet its long-term obligation, it adds to its creditworthiness. Besides, the investors and creditors feel more secure while investing in such ventures.
Both kinds of expenditure coverage ratios are used by external and internal stakeholders. The overall purpose of these ratios is to assess the company’s attractiveness for debt-issuing and investment perspectives.