Thursday, October 06, 2011

Financial Risk Ratios

CFA Level 1 - Financial Ratios


Financial Risk
- This is risk related to the company's financial structure.

Analysis of a Company's Use of Debt
1.Debt to Total Capital
This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier. 

                                                                                               Formula 7.32
Debt to capital = total debt / total capital


Total debt = current + long-term debt
Total capital = total debt + stockholders' equity

2.  Debt to Equity
This ratio is similar to debt to capital.
                                                                                               Formula 7.33
Debt to equity
= total debt / total equity

Analysis of the Interest Coverage Ratio

3.  Times Interest Earned (Interest Coverage ratio)
This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments.

                                                                                          Formula 7.34
Times interest earned
= earnings before interest and tax
            interest expense

4.Fixed-Charge Coverage
Fixed charges are defined as contractual committed periodic interest and principal payments on leases and debt.

                                                                                  Formula 7.35
Fixed-charge coverage
 = earnings before fixed charges and taxes
                      fixed charges

5.Times Interest Earned - Cash Basis
Adjusted operating cash flow is defined as cash flow from operations + fixed charges + tax payments.

                                                                                   Formula 7.36
Times interest earned - cash basis
= adjusted operating cash flow
            interest expense

6.Fixed-Charge Coverage Ratio - Cash Basis
                                                                  Formula 7.37

Fixed charge coverage ratio - cash basis
= adjusted operating cash flow/fixed charges

Capital Expenditure Ratio
Provides information on how much of the cash generated from operations will be left after payment of capital expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times what it will need to reinvest in the business to keep operations going; the excess could be allocated to service the debt.  

                                                                                            Formula 7.38
Capital expenditure ratio
 = cash flow from operations
       capital expenditures

8.     CFO to Debt
Provides information on how much cash the company generates from operations that could be used to pay off the total debt. Total debt includes all interest-bearing debt, short and long term. 
                                                                                              Formula 7.39
CFO to debt
= cash flow from operations / total debt

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