Question

Which two ratios do you think should be of greatest interest in each of the following cases?

a. A pension fund considering the purchase of 20-year bonds.

b. A bank contemplating a short-term loan to a customer.

c. A common stockholder.

Answer 1

Ans- Following ratio should be used of greatest interest in each of the following cases

1. A pension fund considering the purchase of 20-year bonds – Used Price Ratios

1. Bond Equity Earnings Yield Ratio- The bond equity earnings yield ratio (BEER) is a metric used to evaluate the relationship between bond yields and earnings yields in the stock market.

How to Calculate BEER

BEER is calculated by dividing the yield of a government bond by the current earnings yield of a stock benchmark in the same market. The current earnings yield of the stock market (or simply an individual stock) is just the inverse of the price-to-earnings (P/E) ratio, that is, earnings/price. The earnings yield is quoted as a percentage, which measures the percentage of each dollar invested that was earned by a company, sector, or the whole market during the past twelve months. For example, if the P/E ratio of the S&P 500 is 25, then the earnings yield is 1/25 = 0.04. It is easier to compare the earnings yield to bond yields than to compare the P/E ratio to bond yields.

What Does BEER Tell You?

The theory behind the ratio is that if stocks are yielding more than bonds, that is, BEER < 1, then stocks are cheap given that more value is being created by investing in equities. As investors increase their demand for stocks, the prices increase, causing P/E ratios to increase. As P/E ratios increase, earnings yield decreases, bringing it more in line with bond yields.

Conversely, if the earnings yield on stocks is less than the yield on Treasury bonds (BEER > 1), the proceeds from the sale of stocks are reinvested in bonds. This results in a decreased P/E ratio and increased earnings yield. Theoretically, a BEER of 1 would indicate equal levels of perceived risk in the bond market and the stock market.

Analysts often feel that BEER ratios greater than 1 imply that equity markets are overvalued, while numbers less than 1 mean they are undervalued, or that prevailing bond yields are not adequately pricing risk. If the BEER is above normal levels, the assumption is that the price of stocks will decrease, thus, lowering the BEER.

2. Times Interest Earned Ratio : The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations based on its current income. The formula for a company's TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt.

How to Calculate Times Interest Earned (TIE)

Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million in common stock. The company needs to raise more capital to purchase equipment. The cost of capital for issuing more debt is an annual interest rate of 6%. The company's shareholders expect an annual dividend payment of 8% plus growth in the stock price of XYZ.

Companies that have consistent earnings, like utilities, tend to borrow more because they are good credit risks.

The business decides to issue $10 million in additional debt. Its total annual interest expense will be: (4% X $10 million) + (6% X $10 million), or $1 million annually. The company's EBIT is $3 million.

This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.

KEY TAKEAWAYS

• A company's TIE indicates its ability to pay its debts.
• A better TIE number means a company has enough cash after paying its debts to continue to invest in the business.
• The formula for TIE is calculated as earnings before interest and taxes divided by total interest payable on debt.

2. A bank contemplating a short-term loan to a customer – Used Solvency Ratios

1. Interest Coverage Ratio

What you need: Income Statement

The formula: Interest Coverage Ratio = EBIT / Interest Expense

What it means: Both EBIT and interest expense are found on the income statement. It is a measure of how well a company can meet its interest payment obligations. If a company can't make enough to make interest payments, it will be forced into bankruptcy. Anything lower than 1.0 is usually a sign of trouble.

2. Debt to Equity Ratio

What you need: Balance Sheet

The formula:  Debt-to-Equity Ratio = Total Liabilities / Total Shareholder Equity

What it means: Total liabilities and total shareholder equity are both found on the balance sheet. The debt-to-equity ratio measures the relationship between the amount of capital that has been borrowed (i.e. debt) and the amount of capital contributed by shareholders (i.e. equity). Generally speaking, as a firm's debt-to-equity ratio increases, it becomes more risky because if it becomes unable to meet its debt obligations, it will be forced into bankruptcy.

3. A common stockholder- Used Liquidity Ratio & Profitability Ratio

1. Current Ratio

What you need: Balance Sheet

The formula: Current Ratio = Current Assets / Current Liabilities  

What it means: The current ratio measures a company's ability to pay its short-term liabilities with its short-term assets. If the ratio is over 1.0, the firm has more short-term assets than short-term debts. But if the current ratio is less than 1.0, the opposite is true and the company could be vulnerable to unexpected bumps in the economy or business climate.

2. Profit Margin

What you need: Income Statement

The formula: Profit Margin = Net Income / Sales  

What it means: Profit margin calculates how much of a company's total sales flow through to the bottom line. As you can probably tell, higher profits are better for shareholders, as is a high (and/or increasing) profit margin.