losses may occur in the event of stock disposal, it is not wise to rely
upon the sale of stock when measuring a firm's liquidity
Gearing ratios measure a firm's debt level. There
are two types. Debt ratios take figures from a firm's
balance sheet. Whereas, times interest earned ratios
Gearing Ratios take figures from the profit & loss statement.
Debt Ratio Total Debt
Total Assets
Debt ratio measures the extent to which borrowed funds have been
used to finance a firm's operation (ie the proportion of total funds
provided by creditors). Clearly, creditors prefer lower debt ratios, since
they indicate decreased risk of company liquidation. Please note that
total debt = current liabilities + long term liabilities, and total assets =
current assets + fixed assets.
A debt ratio or gearing of 0.5 would indicate that the shareholder funds
were matched by various forms of loan capital. Similarly, a debt ratio
of 0.8 would indicate that the various creditors were supplying £4 to
every £1 supplied by the shareholders.
Times Interest Earned Profit Before Interest & Tax
Interest Paid
Times interest earned measures the extent to which profits may be
allowed to decrease before a firm is forced to default on its annual
loan interest payments. Keep in mind that taxation does not affect a
company's ability to make its interest payments. All interest payments
are deducted from profits prior to declaration.
Activity Ratios Activity ratios measure the efficiency of asset use.
Stock Turnover Turnover
Stocks
Stock turnover measures the amount of stock held by a firm in
relationship to its size. This ratio indicates whether or not the level
of stock held by the firm is reasonable. The significance of the stock
turnover ratio could be increased by replacing the stock value figure
as of the balance sheet date with an average stock value figure for the
year.
Credit Given (Days) Debtors x 365
Turnover
The credit given ratio measures how long a firm waits before collecting
payment from its customers. Some firms record gross turnover rather
than commission earnings. In such cases, this ratio will be distorted.
Credit Taken (Days) Trade Creditors x 365
Cost of Goods Sold
The credit taken ratio measures how much credit a firm is receiving
from its suppliers. As with the measure of days credit given distortions
may arise.
Fixed Asset Turnover Turnover
Chapter Five Terms & Ratios | 51
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