Financial Statement Analysis - Ratio Analysis (Market Value and Coverage)

Ratio analysis is a financial statement analysis technique that is used to gain insights into a company's financial performance by examining its operating efficiency, financial stability, and profitability. Ratios are calculated by dividing one financial statement item by another and can be used to compare a company's performance to those of its peers or to industry averages. They provide useful insights into trends in a company's operations and can help identify potential problems.

Here are the main categories of financial ratios and some examples of each:

Market Value Ratios

They measure a company's market value compared to its financial performance.
Examples:

Price-to-Earnings (P/E) Ratio

This is a financial ratio that measures the value of a company's stock price relative to its earnings per share (EPS). It is calculated as:

P/E Ratio = Market Price per Share / Earnings per Share (EPS)

Example:

Suppose a company's stock is trading at $50 per share and its earnings per share (EPS) is $5. The P/E ratio would be calculated as follows:

P/E Ratio = $50 / $5 = 10

Interpretation:

A higher P/E ratio indicates that the market is willing to pay more for each dollar of earnings and it may suggest that the company is growing or is expected to grow rapidly in the future. On the other hand, a lower P/E ratio may suggest that the market is less optimistic about the company's growth prospects. The industry average should also be considered when interpreting the results.

Market-to-Book (M/B) Ratio

This is a financial ratio that compares the market value of a company to its book value. It is calculated as:

M/B Ratio = Market Capitalization / Book Value

Example:

Suppose a company has a market capitalization of $1,000,000 and a book value of $500,000. The M/B ratio would be calculated as follows:

M/B Ratio = $1,000,000 / $500,000 = 2

Interpretation:

A high M/B ratio may indicate that the market values the company higher than its book value and believes it has good growth prospects. On the other hand, a low M/B ratio may indicate that the market is less optimistic about the company's growth prospects. The industry average should also be considered when interpreting the results.

Coverage Ratios

They measure a company's ability to pay its interest and principal on its debts.
Examples:

Debt Service Coverage Ratio (DSCR)

This is a financial ratio used to evaluate a company's ability to repay its debts. It is calculated as follows:

DSCR = Net Operating Income / Annual Debt Service Payments

A higher DSCR indicates that the company has a better ability to repay its debt, while a lower DSCR indicates that the company may have difficulty repaying its debt obligations.

Example:

Suppose a company has net operating income of $100,000 and its annual debt service payments are $50,000. The DSCR would be 2.0 (100,000 / 50,000).

Interpretation:

This indicates that the company has the ability to repay its debt obligations 2 times over. A DSCR of 1.5 or higher is generally considered favorable by lenders.

Interest Coverage Ratio (ICR)

This is a financial ratio that measures a company's ability to pay its interest expenses. It is calculated as following:

ICR = Earnings before interest and taxes (EBIT) / Interest Expenses.

A higher interest coverage ratio indicates that the company has a better ability to pay its interest expenses, while a lower interest coverage ratio indicates that the company may struggle to pay its interest expenses.

Example:

Suppose a company has earnings before interest and taxes (EBIT) of $500,000 and its interest expenses are $100,000. The interest coverage ratio would be 5.0 (500,000 / 100,000).

Interpretation:

This indicates that the company is generating 5 times the amount of earnings needed to cover its interest expenses. A interest coverage ratio of 3 or higher is generally considered favorable by lenders.