EARNINGS RATIO

Understanding Price to Earnings Ratio

If there is one number that people look at than more any other it is the Price to Earnings Ratio (P/E). The P/E is one of those numbers that investors throw around with great authority as if it told the whole story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)

The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.
You calculate the P/E by taking the share price and dividing it by the company’s EPS.
P/E = Stock Price / EPS
For example, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5).
What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.
Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “diamonds in the rough” before the rest of the market discovered their true worth.
What is the “right” P/E? There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your “right” P/E is all wrong. The articles in this series:

1. Earnings per Share – EPS
2. Price to Earnings Ratio – P/E
3. Projected Earning Growth – PEG
4. Price to Sales – P/S
5. Price to Book – P/B
6. Dividend Payout Ratio
7. Dividend Yield
8. Book Value
9. Return on Equity  

10. Calculating Your Liquidity Ratio

    Current Ratio
    What it is:
    The current ratio is the standard measure of any business' financial health. It will tell you whether your business is able to meet its current obligations by measuring if it has enough assets to cover its liabilities. The standard current ratio for a healthy business is two, meaning it has twice as many assets as liabilities.
    When to use it:
    The current ratio should be part of your business' basic financial planning, meaning it should be tracked monthly or quarterly. By keeping a close eye on this figure, you will recognize if it begins to get out of line. This will allow you to take early action to prevent your business from ending up in a difficult position.
    The formula:
    Current assets divided by current liabilities.
    
    Quick Ratio
    What it is:
    Like the current ratio, the quick ratio (also sometimes called the acid test ratio) measures a business' liquidity. However, many financial planners consider it a tougher measure than the current ratio because it excludes inventories when counting assets. It calculates a business' liquid assets in relation to its liabilities. The higher the ratio is, the higher your business' level of liquidity, which usually corresponds to its financial health. The optimal quick ratio is 1 or higher.
    When to use it:
    This is an important planning tool, especially for businesses that can tie up a lot of assets in inventory. By tracking it monthly, you can keep an eye out for negative trends that could hamper your business' ability to meet its obligations. You can also use the quick ratio to evaluate the financial health of potential customers, since it also indicates whether a business can pay off its debts quickly. A firm with a low quick ratio may be more likely to delay payments because its assets are tied up elsewhere.
    Tip: Take control of your business spending by using charge cards which require you to pay your balance in full each month .
    The formula:
    (Current assets less inventories) divided by current liabilities.
    
    
    How to calculate current ratio?
    An indication of a company's ability to meet short-term debt obligations; the higher the ratio, the more liquid the company is. Current ratio is equal to current assets divided by current liabilities. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liabilities exceed current assets, then the company may have problems meeting its short-term obligations.
    For example, if XYZ Company's total current assets are $10,000,000, and its total current liabilities are $8,000,000, then its current ratio would be $10,000,000 divided by $8,000,000, which is equal to 1.25. XYZ Company would be in relatively good short-term financial standing.
    

    debt/equity ratio

    A measure of a company's financial leverage. Debt/equity ratio is equal to long-term debt divided by common shareholders' equity. Typically the data from the prior fiscal year is used in the calculation. Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt.
    
    For example, if a company has long-term debt of $3,000 and shareholder's equity of $12,000, then the debt/equity ratio would be 3000 divided by 12000 = 0.25. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity.

    Debt-to-Equity ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds.
    It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.
    

    Formula of Debt to Equity Ratio:

    Following formula is used to calculate debt to equity ratio
    
     [Debt Equity Ratio = External Equities / Internal Equities]
    Or
    [Outsiders funds / Shareholders funds]
    As a long term financial ratio it may be calculated as follows:
    [Total Long Term Debts / Total Long Term Funds]
    Or
    [Total Long Term Debts / Shareholders Funds]

    Components:

    The two basic components of debt to equity ratio are outsiders funds i.e. external equities and share holders funds, i.e., internal equities. The outsiders funds include all debts / liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. The shareholders funds consist of equity share capital, preference share capital, capital reserves, revenue reserves, and reserves representing accumulated profits and surpluses like reserves for contingencies, sinking funds, etc. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholder's funds
    Some writers are of the view that current liabilities do not reflect long term commitments and they should be excluded from outsider's funds. There are some other writers who suggest that current liabilities should also be included in the outsider's funds to calculate debt equity ratio for the reason that like long term borrowings, current liabilities also represents firm's obligations to outsiders and they are an important determinant of risk. However, we advise that to calculate debt equity ratio current liabilities should be included in outsider's funds. The ratio calculated on the basis outsider's funds excluding liabilities may be termed as ratio of long-term debt to share holders funds.
    

    Example:

    From the following figures calculate debt to equity ratio:
    

    Equity share capital Capital reserve Profit and loss account 6% debentures Sundry creditors Bills payable Provision for taxation Outstanding creditors

    1,100,000 500,000 200,000 500,000 240,000 120,000 180,000 160,000

    Required: Calculate debt to equity ratio.

    Calculation:

    External Equities / Internal Equities
    = 1,200,000 / 18,000,000
    = 0.66 or 4 : 6
    It means that for every four dollars worth of the creditors investment the shareholders have invested six dollars. That is external debts are equal to 0.66% of shareholders funds.
    

    Significance of Debt to Equity Ratio:

    Debt to equity ratio indicates the proportionate claims of owners and the outsiders against the firms assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm. However, the interpretation of the ratio depends upon the financial and business policy of the company. The owners want to do the business with maximum of outsider's funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsiders creditors) on the other hand, want that shareholders (owners) should invest and risk their share of proportionate investments. A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or standard norm for all types of businesses. Theoretically if the owners interests are greater than that of creditors, the financial position is highly solvent. In analysis of the long-term financial position it enjoys the same importance as the current ratio in the analysis of the short-term financial position.
11. A ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period:
    
     

    Investopedia explains 'Interest Coverage Ratio'

    The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.
    

    Return on Equity (ROE)

    What It Is:

    Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders' equity. The formula for ROE is:
    
    ROE = Net Income/Shareholders' Equity
    
    ROE is sometimes called "return on net worth."
    

    How It Works/Example:

    Let's assume Company XYZ generated $10,000,000 in net income last year. If Company XYZ's shareholders' equity equaled $20,000,000 last year, then using the ROE formula, we can calculate Company XYZ's ROE as:
    
    ROE = $10,000,000/$20,000,000 = 50%
    
    This means that Company XYZ generated $0.50 of profit for every $1 of shareholders' equity last year, giving the stock an ROE of 50%.
    

    Why It Matters:

    ROE is more than a measure of profit; it's a measure of efficiency. A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital. It also indicates how well a company's management is deploying the shareholders' capital.
    
    It is important to note that if the value of the shareholders' equity goes down, ROE goes up. Thus, write-downs and share buybacks can artificially boost ROE. Likewise, a high level of debt can artificially boost ROE; after all, the more debt a company has, the less shareholders' equity it has (as a percentage of total assets), and the higher its ROE is.
    
    Some industries tend to have higher returns on equity than others. As a result, comparisons of returns on equity are generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.

     

    Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR)^[1], is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements.
    

    Formula

    Capital adequacy ratios ("CAR") are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset.
    Capital adequacy ratio is defined as
     
12.  TIER 1 CAPITAL - (paid up capital + statutory reserves + disclosed free reserves) - (equity investments in subsidiary + intangible assets + current & b/f losses)
    TIER 2 CAPITAL -A)Undisclosed Reserves, B)General Loss reserves, C) hybrid debt capital instruments and subordinated debts
     
13. where Risk can either be weighted assets  or the respective national regulator's minimum total capital requirement. If using risk weighted assets,
     
    The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator of different countries.
    Two types of capital are measured: tier one capital , which can absorb losses without a bank being required to cease trading, and tier two capital , which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
    

    Use

    Capital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities and other risks such as credit risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.^[1]
    CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk.
    

    Risk weighting

    Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR.
    

    Risk weighting example

    Risk weighted assets - Fund Based : Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets.
    Non-funded (Off-Balance sheet) Items : The credit risk exposure at­tached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the Credit Conversion Factor. This will then have to be again multiplied by the relevant weightage.
    Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting.

Types of capital

The Basel rules recognize that different types of equity are more important than others. To recognize this, different adjustments are made:

1. Tier I Capital: Actual contributed equity plus retained earnings.
2. Tier II Capital: Preferred shares plus 50% of subordinated debt.

Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets may be 4%, while minimum CAR including Tier II capital may be 8%.
There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the jurisdiction.