Financial Statements and Firm Value 117interest expense taken from the income statement. It is to be noted that these ratios do not measure risk of
default. The riskiness is measured by volatility of earnings (EBIT) which is dependent on the industry
condition, profitability, etc. So a high ratio in one industry or during economic boom may be ‘low’ in another
industry or during economic recession. Put differently, these ratios are forward looking in nature
Fixed Charges Coverage Ratio
Computation:
Fixed charges
lease payments and current portion of long term- debtEarnings beforeinterest and taxes+ Fixed charges likeMeaning: Fixed charges coverage ratio, a variant of interest coverage ratio, takes into account other fixed
financial obligations of the firm while measuring the (financial obligation) servicing ability. It might be
better to take cash flows rather than earnings in the numerator. Cash flow from operation = Profit after tax +
non-cash charges like depreciation, amortization, and depletion.
DEBT RATIOS
These ratios measure the indebtedness of the firm. Firms with high amount of debt relative to equity are
considered highly levered and are vulnerable to business downturns. It must be remembered that they vary
according to the capital requirements of the business, stability of earnings, etc.
Debt/ Net Worth
Computation:
Variant 1: Long-term debt divided by tangible net worth
(Share capital plus reserves and surplus).
Variant 2: Total liabilities divided by net worth.
Meaning: This ratio measures the amount of debt employed by the firm. It is a measure of financial risk.
A high ratio is generally viewed as risky since the firm is vulnerable to recession. When earnings fall, the
firm may have difficulty in servicing debt. The higher the equity contribution (owner’s capital), the greater
is the protection provided to creditors.
Debt/Total Assets
Computation: Long-term debt divided by total assets (balance sheet total).
Meaning: This ratio measures the amount of debt as a fraction of total capital employed.
Total Assets/Equity
Computation: Total assets (balance sheet total) divided by net worth.
Meaning: This ratio measures the extent to which equity has been invested in total assets. A variant of this
ratio: Net fixed assets divided by equity.
Usually, only long-term debt is used in computation. A variant of this ratio incorporates short-term bank
borrowings also.
Ratios Measuring Funds Management Turnover Ratios
These ratios are useful in ascertaining the efficiency of funds management. Some of the popular ratios are
discussed here: