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IS524: Financial Accounting
Ratio Calculations
Debt (Leverage) Ratios
Description:
Debt (leverage) ratios are calculated for a company to get an idea of a firm’s methods of
financing or to measure the firm’s ability to meet financial obligations. Several ratios are widely
used, with most ratios taking into consideration a firm’s debt, equity, assets and interest
expenses.
By calculating and comparing debt (leverage) ratios, we try to get an idea of trends in sources of
financing and whether the firm can meet its financial obligations in light of its financing mix.
1. Debt-to-Equity Ratio
Description:
The debt-to-equity ratio is another measure of a firm’s financial leverage. The ratio indicates
what proportion of equity and debt the firm is using to finance its assets. For debt, while some
calculate this portion by using “Total Liabilities,” a more useful measure is to look at total
interest-bearing debt (which takes into account both the principal and interest of borrowing).
Formula:
Debt-to-Equity Ratio = Total Interest-Bearing Debt / Shareholders’ Equity
Interpretation:
A high debt-to-equity ratio may indicate that a firm has been aggressive in financing growth
using debt. One consequence may be that this can result in volatile earnings because of
additional interest expense.
On the one hand, a lot of debt may help the firm generate more earnings than it would have
without this financing. If using debt helps to increase earnings by a greater amount than the cost
of financing (interest), then shareholders would benefit. However, if the cost of debt financing
outweighs the returns of the firm due to interest burden, this may ultimately lead to bankruptcy.
In addition, it is important to note that the amount of debt employed may vary from industry to
industry.
2. LT Debt-to-Equity Ratio
Description:
In measuring the long-term debt-to-equity ratio, the ratio indicates the proportion of long-term
debt to total equity for a firm. This gives users of financial statements an idea of the long-term
financial obligations of the firm as a portion of total equity and helps to assess the ability to meet
these obligations.
Formula:
LT Debt-to-Equity Ratio = Total Interest-Bearing LT Debt / Shareholders’ Equity
Interpretation:
Similar to the debt-to-equity ratio, a high ratio may indicate that a firm has been aggressive in
financing growth using debt. In addition to potential earnings volatility due to additional interest
expense payments, noting the trends in debt financing (sudden increase or gradual decrease) is
also useful in helping to gauge whether debt levels are sustainable for the firm.
3. Net Debt-to-Equity Ratio
Description:
The net debt-to-equity ratio extends the debt-to-equity ratio by taking into consideration the
amount of cash the company has on hand to meet current debt obligations. In the event that a
firm would have to liquidate and pay back all creditors, the net debt-to-equity ratio helps users of
financial statements to see how much cash the firm has in order to meet its outstanding debt
obligations.
Formula:
Net Debt-to-Equity Ratio = Net Debt / Shareholders’ Equity
where
Net Debt = Total Interest-Bearing Debt – Cash
Interpretation:
In general, the lower the ratio, the lower the financial risk to the firm in terms of debt levels
given its current cash levels and the proportion of this to total equity.
Profitability Ratios
Description:
Profitability ratios are calculated to assess a business’ ability to generate earnings compared to its
expenses and other costs incurred over a specific period of time. For most profitability ratios, a
higher value relative to a competitor’s ratio or similar ratios from a previous period generally
indicate that the firm is doing well.
1. Gross Margin
Description:
The gross margin represents the percent of total sales that a firm retains after incurring direct
costs of producing the goods and services. The higher the percentage, the more the firm retains
on each dollar of sales to service other costs and obligations.
Formula:
Gross Margin (%) = Gross Profit / Sales
where
Gross Profit = Sales – Cost of Goods Sold (COGS)
Interpretation:
Gross margin represents the proportion of each dollar of sales that the firm retains as gross profit.
For example, if a firm’s gross margin was 50% for the year 2012, this means that the company
would retain $0.50 from each dollar of sales generated that can be used to pay off operating
costs, financing costs, as well as taxes.
2. Operating Margin
Description:
The operating margin measures what proportion of a firm’s revenue is left over after paying for
variable costs, such as wages and raw materials. In general, a healthy (high) operating margin is
required for a firm to pay off other fixed costs, such as interest on debt.
Formula:
Operating Margin (%) = Operating Profit / Sales
Interpretation:
The operating margin gives an idea of how much a company makes (before interest and taxes) on
each dollar of sales. It is important to look at the change in operating margin over time and to
compare the firm’s margins with those of competitors. If margins are increasing, the firm is
earning more per dollar of sales. As such, the higher the margin, the better.
3. Net Margin
Description:
The net margin describes the ratio of net profit to sales for a firm and shows how much of each
dollar earned by the firm is translated into profits.
Formula:
Net Margin (%) = Net Profit / Sales
Interpretation:
The net profit margin indicates how much a company makes on each dollar of sales after
considering financing costs as well as the effect of taxes. Similar to other profitability margins,
in general, higher margins are better and increasing margins over time is a good sign.
It is also important to be aware of margin differences depending on the industry. Industries such
as the retailing industry may not experience high net margins, but are able to create a lot of value
for shareholders through dividends, etc. On the other hand, some technology firms may be able
to generate high net profit margins, but this should be checked against margins for other
competitors and how this translates into benefit for shareholders.
4. Return on Assets (ROA)
Description:
Return on assets (ROA) is an indicator of how profitable a firm is relative to its total assets. ROA
shows how efficient management is at using assets to generate earnings.
Formula:
ROA (%) = Net Profit / Average Total Assets
Interpretation:
ROA shows the amount of earnings generated from a firm’s assets. ROA can vary over time and
will also be dependent on the industry. As such, ROA should be used as a comparative measure
against a firm’s previous ROA calculations and those of competitors. In general, the higher the
ROA, the better, as this shows that a firm can generate more earnings with less money or
resources.
5. Return on Equity (ROE)
Description:
Return on equity (ROE) represents the amount of net income generated as a percentage of
shareholders equity. ROE measures a firm’s profitability by revealing how much profit a
company generates with money invested by shareholders.
Formula:
ROE (%) = Net Profit / Average Shareholders’ Equity
where
Shareholders’ Equity does not include preferred shares
Interpretation:
From a shareholder’s perspective, ROE allows us to analyze how effective the company has been
in investing shareholders’ resources and generating returns. In general, the more returns the firm
is able to generate, the better the job management has done in investing shareholders’ resources.