Current Ratio – Formula, Meaning, Assumptions and Interpretations
The current ratio is the most popularly used metric to gauge the short term solvency of a company. This article provides the details about this ratio. Formula Current Ratio = Current Assets / Current Liabilities Meaning Current ratio measures the current assets of the company in comparison to its current liabilities. This means that the…
What are Common Size Statements ?
Common size statements are not financial ratios. Rather they are a way of presenting financial statements that makes them more suitable for analysis. However, analysts always use them in conjunction with ratio analysis. In fact, financial analysts use common size statements as the starting point to help them dig deeper. Common size statements tell them…
Introduction to Cash Flow Ratios
Once upon a time, investors and analysts used to believe in ratios that have been calculated based on the earnings that the company has stated in the Income Statement. Alas! That was once upon a time. Of late, there have been a huge number of frauds and malpractices that have come to the fore. All…
A high debt equity ratio makes the company financed by debt more than by equity. Therefore there are fixed interest payments involved. Hence when the going is good, the company makes a handsome return as a small percentage of change in EBIT creates a large percentage change in earnings per share. However the inverse of this is also true. Just like financial leverage helps to magnify profits, it also magnifies losses when EBIT fall down. Analysts want to quantify exactly how much variability does debt funding create in the operations of a particular company and have created a measure called “Degree of Financial Leverage” which we will study in detail.
Degree of Financial Leverage = % Change in EPS / % Change in EPS
There is a reasonable assumption about the absence of any changes in accounting policy which would make the EPS and EBIT figures incomparable from the previous years.
Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Lets say that the price of the house went up by 20% to 120. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 43. Since your original investment was Rs 30, you have gained Rs 13.
A price increase of 20% has led to an increase in the shareholders return by approximately 43%!
Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Lets say that the price of the house went down by 20% to Rs 80. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 3. Since your original investment was Rs 30, you have lost Rs 27.
A price decrease of 20% has led to a decrease in the shareholders return by approximately 90%
Leverage is very dangerous unless the company is reasonably certain of its earnings. Investors view the leverage ratio with great detail. This is because it enables a small change in the EBIT to completely wipe out the company’s capital and make it insolvent almost overnight.
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