Question

Comment on 2 financial ratios and discuss how the ratio is a "double edged sword" and can be possibly too good.

Answer 1

Two current ratios:

1. Interest Coverage Ratio:
   The interest coverage ratio is also referred to as debt service ratio or the debt service coverage ratio. The interest coverage ratio helps us understand how much the company is earning relative to the interest burden of the company. This ratio helps us interpret how easily a company can pay its interest payments. For example, if the company has an interest burden of Rs.100 versus an income of Rs.400, then we clearly know that the company has sufficient funds to service its debt. However a low interest coverage ratio could mean a higher debt burden and a greater possibility of bankruptcy or default.

The formula to calculate the interest coverage ratio:
[Earnings before Interest and Tax / Interest Payment]

The ‘Earnings before Interest and Tax’ (EBIT) is:

EBITDA – Depreciation & Amortization

Now, usually, when one says that their interest coverage ratio is more than 1 it is acceptable for lenders to give loan to the party. But if the interest coverage ratio it too high, that would suggest that the company is making too much profit and so would make the banker think that they could charge higher interest to the party as the party can easily afford them, thus can fool the borrower or argue with them to take loan at higher interest rates.

2. Debt to Equity Ratio:
   This is a fairly straightforward ratio. Both the variables required for this computation can be found in the Balance Sheet. It measures the amount of the total debt capital with respect to the total equity capital. A value of 1 on this ratio indicates an equal amount of debt and equity capital. Higher debt to equity (more than 1) indicates higher leverage and hence one needs to be careful. Lower than 1 indicates a relatively bigger equity base with respect to the debt.

So , when the ratio is higher that shows that the company is operating with others money and not their own as their debt is more than their own money invested.

And the ratio is less than , it shows that equity is more than debt, but in this situation the company loses because they need to pay more money on money invested by equity than on debt ,a s cost of debt is less than equity.

Two current ratios:

1. Interest Coverage Ratio:
   The interest coverage ratio is also referred to as debt service ratio or the debt service coverage ratio. The interest coverage ratio helps us understand how much the company is earning relative to the interest burden of the company. This ratio helps us interpret how easily a company can pay its interest payments. For example, if the company has an interest burden of Rs.100 versus an income of Rs.400, then we clearly know that the company has sufficient funds to service its debt. However a low interest coverage ratio could mean a higher debt burden and a greater possibility of bankruptcy or default.

The formula to calculate the interest coverage ratio:
[Earnings before Interest and Tax / Interest Payment]

The ‘Earnings before Interest and Tax’ (EBIT) is:

EBITDA – Depreciation & Amortization

Now, usually, when one says that their interest coverage ratio is more than 1 it is acceptable for lenders to give loan to the party. But if the interest coverage ratio it too high, that would suggest that the company is making too much profit and so would make the banker think that they could charge higher interest to the party as the party can easily afford them, thus can fool the borrower or argue with them to take loan at higher interest rates.

2. Debt to Equity Ratio:
   This is a fairly straightforward ratio. Both the variables required for this computation can be found in the Balance Sheet. It measures the amount of the total debt capital with respect to the total equity capital. A value of 1 on this ratio indicates an equal amount of debt and equity capital. Higher debt to equity (more than 1) indicates higher leverage and hence one needs to be careful. Lower than 1 indicates a relatively bigger equity base with respect to the debt.

So , when the ratio is higher that shows that the company is operating with others money and not their own as their debt is more than their own money invested.

And the ratio is less than , it shows that equity is more than debt, but in this situation the company loses because they need to pay more money on money invested by equity than on debt ,a s cost of debt is less than equity.