ACCOUNTING RATIOS – PART 2

According to my previous article, I discussed two major categories of ratios: profitability and liquidity. The Solvency and Stock Market ratios will be discussed in greater detail today.

Solvency Ratio

They analyze a company’s long-term paying ability and financing structure. We have various types of solvency ratios. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term liabilities and, thus, is a measure of its financial health. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations. They include:

1. Debt Ratios – The term debt ratio refers to a financial ratio that measures the extent of a company’s leverage. This ratio varies widely across industries. A debt ratio greater than 1.0 (100%) indicates that a company has more debt than assets. Meanwhile, a debt ratio of less than 100% means that a company has more assets than debt. Here, we have two different ways to express the same relationship.

Debt to asset ratio – It measures the percentage of a company’s assets that are financed by debt. Its formula is expressed as:

= Total liabilities/Total assets

Debt to equity ratio – It compares creditors’ financing to owners’ financing. Its formula is expressed as:

= Total liabilities/total stockholders’ equity

• No of times interest is earned – This ratio calculates or measures the burden a company’s interest payments represent. Its formula is expressed as:

= Earnings before interest and tax expense (EBIT)/Interest expense

Another common ratio under this category is:

Number of times the preferred dividend is earned = Net income(after tax) / Amount of the preferred annual dividend

• Plant asset to long-term liabilities – this means the ability of a Firm to obtain long-term financing on the strength of its asset base. Its formula is expressed as:

= Net plan assets/long-term liabilities

Stock Market Ratios

This involves analyzing and comparing the earnings and dividends of companies in various industries.

1. Earnings per share – Earnings per sharemeasures a company’s profitability. When buying a stock, you participate in the company’s future earnings (or risk of loss). Investors use it to gain an understanding of company value. Its formula is expressed as:

= Net earnings available to common stock / Average Number of outstanding common shares

• Book value – Book value per shareis another frequently quoted measure of a share of stock. Its formula is expressed as:

= Stockholders equity – preferred rights/outstanding common shares

Preferred rights represent the amount of money required to satisfy the claims of preferred stockholders.

• Price-earnings ratio – This compares the earnings per share of a company to the market price for a share of the company’s stock. Investors use this ratio to determine a stock’s potential for growth. It is also known as the P/E ratio. Its formula is expressed as:

= Market price per share / Earnings per share

• Dividend yield – The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price. A company with a high dividend yield pays a substantial share of its profits in dividends. A company’s dividend yield is always compared with the average of the industry to which the company belongs. Its formula is expressed as:

= Dividends per share/Market price per share

Conclusion

The solvency ratio is one of the most important ratios used by investors to identify undervalued stocks that increase in price over time. It provides a comprehensive understanding of a company’s solvency and its ability to generate enough cash to pay off its long-term debt. As an investor, you can use solvency ratios to analyse a company in the process of investing.

However, the market value ratios can help determine whether a company’s stocks are overvalued, undervalued, or rightly valued. You can also figure out the optimal prices at which the shares should be bought or sold. Other than evaluating the current share price of a public company’s stock, these metrics also help existing and potential investors to make financial decisions about investing in shares.

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Written by Tutty Tero