Asset Turnover

Asset Turnover measures the company’s efficiency, productivity at using its assets in generating sales or revenue. Sometimes this ratio is referred as efficiency ratio, asset utilization ratio or asset management ratio.

Every company had assets of some sort, even it’s a home based business or an international conglomerate, and every company produces goods and services for sale to a consumer market. The asset turnover can be very helpful in measuring progress in each and every area.

Asset Turnover indicates the relationship between the net assets employed and the revenue it yields. This ratio is useful to determine the amount of sales that are generated from each penny of assets. Therefore this ratio is much useful for the growth of the companies to check whether their growing revenue is proportion to sales.  A company should have a proper balance maintained between debt and equity. It indicates a pricing strategy as companies with low profit margins tend to have high asset turnover and those with high profit margins have low asset turnover.

High ration is considered desirable for the company, it indicates the company operating performance. A higher asset turnover ratio represents greater shareholder wealth. A low asset ration means inefficient utilization of fixed assets. Revenue value can be taken from the company’s income statement and the net assets from the balance sheet.

Asset Turnover   =    Revenue

                               Net assets

Debt to Total Assets Ratio

Debt to Total Assets ratio measures a company's financial risk which determines how much of company’s assets have been financed by debt. This ratio measures company’s solvency as well. This is a very broad ratio which includes all the short-and long-term debt and all types of both tangible and intangible assets.

If the ratio is less than one indicates the company’s assets are financed through equity. Same as that ratio is greater than one, most of the company’s assets are financed through debt. Higher the ratio the greater the risk will be associated. More than that higher the ratio indicates the low borrowing capacity of a firm, which in turn will indicate financial flexibility. The number it yields tells investors a number of things.

To improve the Debt to Assets ratio, a company could do so many things like debt-equity swap, an additional stock issue or selling assets to pay down some of the debt. Therefore companies use strategies depending on the conditions and how much they want to improve that debt/asset ratio number.

Actually this ratio differ from one company to another, depend on the company specific situations. Some companies manage to do well with the high no ratio due to number of reasons.

Total Debt x 100

 Total Assets

Advantages and Disadvantages of High Gearing

Advantages of High Gearing

Borrowing may allow the firm to take on profitable projects

Taking on more profitable projects may allow the company to expand and in the future reduce its Gearing ratio

Borrowing may be a quick and cheap form of financing a project compared to other means such as share issues which may not all be taken up

Disadvantages of High Gearing

If the company has low profits then it may struggle to meet interest payments, leading to a higher risk of being liquidated

The firm may find it harder to get further loans, since investors will be put off by the high gearing level

Advantages and Disadvantages of Low Gearing

Advantages of Low Gearing

Changes in interest rates especially upward trends have a lower effect on the firm

Less risk of liquidation occurring due to not being able to pay off interest payments

Reduced Interest payments, so more investment can occur elsewhere and the firm can have more cash flow to take on bigger and potentially more profitable projects

Disadvantages of Low Gearing

The firm is expected to make regular dividend payments

The higher ratio of Shareholder funds will mean that the company will now be owned by its shareholders more relatively.

Gearing Ratio

Gearing Ratio I

Gearing Ratio            =                         Debt x 100

                                                             Equity

Variations to the basic quantification,

Gearing Ratio II

Gearing Ratio         =        Debt       x 100

                                        Debt + Equity

Expresses debt as a function of total   funding profile

What is Gearing?

Gearing is a tool that is used by investors and businesses to show how much of the long term finance came from loans and how much came from shareholder funds. It also shows how exposed the firm is to financial risk.

Gearing Ratio

The Gearing Ratio looks at the level of borrowing that a company has taken on in the form of loans and compares that to the total long term finance that a business has.

As a ratio, obtain a percentage figure from the formula. Since the formula shows the ratio of Loans to (shareholder funds + Loans), the percentage obtained tells us a few things.

High Gearing – where a high % of the long term finance is in the form of loans. A high percentage is a figure that is over 50%.

Low Gearing – where a low % of the long term finance is in the form of loans. A low percentage is a figure that is between 0% and 50%

What Does the Gearing Figure mean for the Business and Shareholders?

Gearing shows a firms exposure to financial risk. A high gearing percentage tells us that the firm has a high level of loans compared to shareholder funds. The high level of loans also means that the firm has to pay a higher interest charge. This means that if profits were low, or did not meet predicted levels then the firm would have a tough time paying off the interest charges, which would affect other areas of the firm e.g. a lower investment into Research & Development for a year. So the greater the gearing percentage the greater the exposure to risk and the risk of interest rate rises.

For shareholders and potential investors the gearing level is important, and as such it is a very important tool when analyzing whether a business is a viable investment:

Potential investors view firms that are highly geared as being a risky investment

Higher gearing raises the exposure to interest rate changes, so investors will be put off investing if they feel that interest rates will rise

Higher gearing means that the company will be in risk of liquidation if it cannot meet interest payments

Investors looking to give a loan to the company will also look at the gearing ratio

A highly geared company will already be paying high interest charges, so investors will be put off from give it a further loan as the firm may not be able to pay it back

A low geared firm is more likely to get a loan from investors since its loan payments are low, and its exposure to risk is also low.

Interest Cover

While the gearing ratio measures the relative level of debt and long term finance, the interest cover ratio measures the cost of long term debt relative to earnings. In this way the interest cover ratio attempts to measure whether or not the company can afford the level of gearing it has committed to.

The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

Interest Cover                 =        Operating Profit                                                                                                                                         Interest Expense

Quality of Profit

The quality of profit is measured by the ratio of net cash inflow from operations divided by earnings before interest and taxes (EBIT). This indicates the amount of profit received in cash terms during the year.

Cash is the fuel that enables your business to survive and allows you to grow. This measure combines cash and operational profit in such a way that you can track your sustainability along with your cash position. You also get another view of your collection efficiency, making sure you collect money for all that work you’ve done.

In addition, it filters out extraordinary items and debt so you’re not lulled into thinking that because you have cash in the bank everything’s. You may be living on asset sales or your line of credit while the business deteriorates only to have a nasty surprise when it’s too late. Growth consumes capital, and especially in a high-growth situation you may outgrow your own capital base. Once the growth train picks up a head of steam, being surprised by the cash crunch is more than an inconvenience; you could get completely derailed.

Quality of Profits               =              Net Cash flows from Operating Activities

                                                                       Operating profits

The quality of profit is measured by the ratio of net cash inflow from operations divided by earnings before interest and taxes (EBIT). This indicates the amount of profit received in cash terms during the year and also ‘Quality of profit’ ratio is used to measures the company’s health.

Cash is the fuel that enables your business to survive and allows you to grow. This measure combines cash and operational profit in such a way that you can track your sustainability along with your cash position. You also get another view of your collection efficiency, making sure you collect money for all that work you’ve done.

Quality of profit gives a much clearer view of the real position of a company and helps you determine if the company is healthy enough to undertake some significant initiative. Strategic decisions, especially those regarding investments, can be made from a much more solid foundation. Any major new effort has plenty of inherent risk, and knowing what to prioritize and fix first mitigates that risk.

Showing the quality of profit measurement to a buyer, banker or investor will help them fully understand health and value of your company.

Cash Flow Adequacy Ratio

 

Cash Flow Adequacy Ratio indicates a company's capability of covering capital expense, debt repayment and dividends from cash flow generated from operating activities. 

 

Cash Flow Adequacy =            Net Cash flows from Operating Activities

                                                          Current Liabilities

Significance:

Cash flow adequacy is the primary measure of cash sufficiency. This performance ratio should have a value of 1 or higher. A ratio of 1 or more indicates that the company's operations produce sufficient cash to meet necessary business obligations. A ratio of less than one indicates potential liquidity problems.