However this ratio alone is not enough to determine whether a firm has too much

However this ratio alone is not enough to determine

This preview shows page 57 - 60 out of 107 pages.

However, this ratio alone is not enough to determine whether a firm has too much debt. Debt has the potential of being a low-cost solution to growth and may provide an opportunity for a firm to expand. On the other hand, too much debt will increase the fixed payments that a firm is subject to and will likely increase the default risk. The point here is that although the debt ratio can assist in understanding the debt load of a firm, it may not be appropriate to draw a conclusion based on this one ratio alone because debt has benefits and depends on the industry that the firm belongs to. The solvency ratio is also a ratio that is intended to measure a company’s ability to pay its long-term obligations. This ratio shows an analyst how likely a company will be able to meet its debt obligations. The solvency measure is calculated as follows: Solvency Measure= After Tax Net Profit+ Depreciation/ Long Term Liabilities + Short Term Liabilities Similar to the debt ratio, there is no ideal figure in terms of the solvency ratio. The appropriate ratio level depends on the industry. However, you can draw a general conclusion in that the lower a company’s solvency ratio, the greater the probability that the company will default.
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The following video takes a deeper look at solvency ratios: Activity Although there are many ratios that fall under this category, those that are discussed here are some of the more common. Receivables turnover is computed as sales divided by the accounts receivable. This ratio shows how a firm is collecting on its receivables. Generally, it would be preferred that this comes back higher because this would imply that a firm is collecting on its receivables sooner. This ratio can be often moved in response to credit policies that are extended to customers. The days' receivables ratio indicates how long, in days, a firm takes to collect on its receivables. This is calculated as follows: Days Receivables Ratio= 365/ Receivables Turnover The next two ratios that are included in this lesson revolve around inventory. The first is the inventory turnover ratio , which is calculated as follows: Inventory Turnover Ratio= COGS (cost of goods sold)/Inventory Given that the movement of inventory results in sales, a higher ratio can be interpreted as better. The second ratio that involves inventory is the days’ inventory ratio , which indicates how long inventory sits before it is sold. Although holding inventory is necessary to satisfy customers’ orders, this comes at a cost. A firm would not want this figure to be too high because it may imply unnecessary storage cost and may result in inventory that is outdated. This ratio is calculated as follows: Days Inventory Ratio= 365/Inventory Turnover Efficiency
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The three efficiency ratios that help in gauging a firm’s operating efficiency are the following: The total asset turnover The fixed-asset turnover The equity turnover The total asset turnover measures a company’s ability to produce sales given its investment in total assets. Those firms that are capital-intensive are
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