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