Ratios to help debt investor make an informed choice

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A debt investor is one who invests in debt instruments of a company or a bank. (Reuters) A debt investor is one who invests in debt instruments of a company or a bank. (Reuters)
SummaryWe invest money to meet our future monetary requirements, which are uncertain to predict.

of a company to meet all its fixed obligations such as lease payments. This ratio is called fixed charges coverage ratio. Higher the fixed charges cover, the better is the performance of the company.

Current and liquidity ratio: These ratios are normally used by lending institutions to assess the liquidity of a company. The current ratio is computed by dividing the amount of its current assets by its current liabilities amount. A very high current ratio may not be favourable due to the possibility of the entity having very high amount of inventories and poor quality accounts receivable, which are not preferable from the profitability and liquidity perspectives. Acid test or liquidity ratio is computed by dividing the monetary current assets by the current liabilities of the company where monetary current assets are arrived by subtracting the inventories and prepaid expenses amount from the total current assets amount.

Debt-equity ratio: This ratio is calculated by dividing the total amount of debt by the amount of owner’s equity or shareholder funds. Here, one can take either the total of current and long-term liabilities or only the long-term liabilities into the definition of debt. This ratio is computed to measure the long-term ability of a company to meet its financial obligations, i.e., solvency. Lower the debt equity ratio, the better is the solvency position.

Value-to-Ebit ratio: This ratio is calculated by dividing the firm value by the Ebit amount. Here, firm value refers to the sum of the market value of the equity shares and the market value of the debt of the company. This ratio is equivalent to the computation of P/E ratio for an equity investor. This ratio enables an investor to value a company on relative basis , i.e., to find out whether the company is under or over valued in relation to its peers. This ratio is normally used in valuing a company under the mergers and acquisitions or other valuation scenarios.

The author teaches accounting and finance courses at IIM Ranchi

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