Financial ratios involve the comparison of two numbers for the purposes of evaluating the financial health of a firm. Investors, lenders, regulators, journalists and internal stakeholders use ratios to measure performance. Lenders want to know that they'll be repaid, and they use financial ratios to evaluate the likelihood of default. There are dozens of types of ratios, each of which is appropriate for a given situation. When lending to businesses, commercial banks typically evaluate the coverage ratios and the debt to equity ratios.
Banks and lenders may want to know a firm's ability to cover interest charges. They do this by calculating the interest coverage ratio. The formula for this ratio is earnings before interest and taxes divided by interest. What this ratio evaluates is the percentage of a company's earnings that is devoted to interest payments. Banks may use this ratio when evaluating whether to lend additional money to a firm. They may also use coverage ratios as part of a debt covenant.
Fixed Charge Coverage
Firms in financial trouble may be able to lay off some employees and otherwise reduce expenses. Fixed charges -- such as rent, overhead and insurance, which may not be related to the overall productivity of the firm -- not decline if the company lays people off. The formula for the fixed charge ratio is the net income before interest and taxes, plus fixed charges divided by fixed costs.
Debt to Equity
The debt to equity ratio measures the degree to which a company's lenders finance a company's operations when compared to a company's lenders. To calculate the debt to equity ratio, divide total debt by shareholder's equity. One problem with this calculation, especially for fairly old companies, is that businesses account for the value of their equity by the amount for which they sold stock. For example, a company may have incorporated in 1920 and sold stock for $1 per share. The sale of that stock may stay on the company's books at $1 per share even though it is sold on stock exchanges for $12 per share.
Book Value Vs. Market Value
The difference between the equity of a company on its financial statements, which accounts for the value of stock according to the price at which it was issued, and the value of stock on the stock exchange is a comparison of its book value with market value. It may be more difficult to calculate the market value of a company -- the sum of its stock value -- but it may be more appropriate to use market value when calculating debt to equity in very old companies. However, because financial service firms typically use the book value when calculating debt to equity, using the book value may be more valuable when comparing a firm to its competitors.
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