We invest money to meet our future monetary requirements, which are uncertain to predict. However, the decision-making process should be evaluated on the basis of a specific investment’s ability to offer higher profits or returns, better safety to the principal amount invested and the ease at which the investment can be converted into cash, also known as liquidity. In this context, the question is how to assess the profitability, safety and liquidity of an investment.
Important ratios for a debt investor
A debt investor is one who invests in debt instruments of a company or a bank.
Return on invested capital (ROIC): This ratio is computed by dividing the after-tax operating profit by the amount of invested capital. The resulting number is multiplied by 100 as it is always expressed as a percentage figure. Here, operating profit refers to the earnings before interest and taxes (Ebit), which is the profit from only the core activities of a business unit that is available for the entire firm (or both the debt and equity investors). Since tax is an obligatory expense, we subtract the tax expense from the Ebit number.
Invested capital refers to the long-term capital employed by a firm, which does not include the amount of current liabilities in it. Higher the ROIC, the better is the performance of a company. This ratio measures the overall performance of a company. One may compute the ROIC of the analysed company for the past five years and also for the next three years based on the projected financial statements.
Interest/fixed charges cover: This is computed by dividing the Ebit figure by the amount of interest expense of the company. This ratio is expressed in number of times; hence, we need not multiply the output by 100.
The higher the interest cover, the better is the ability of the company to meet its interest payment obligations. Again, one can compute this ratio for the analysed company for the past and future, to arrive at a trend that would communicate the company’s attractiveness for investment. This ratio can be extended to find out the ability 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