Purchasing and Financing 2024

Investors are either expecting an increase in future earnings or are paying too much for
the stock.
2. Debt Equity Ratio = Debt/Owner's Equity
The Debt Equity Ratio is one of the most widely used Financial Ratios. It indicates how
much of the company is financed by debt, the higher the ratio, the higher the debt.
Generally, ratios of higher than 1 indicate more risk in financing assets. As with any
Financial Ratio, owners and investors compare the ratio to the industry average and the
competition.
3. Interest Coverage Ratio (Income Statement) = Operating Income/Interest Expense
The Interest Coverage Ratio measures the ability of a firm to meet its interest payments.
The larger the ratio, the more likely the firm can meet its payments.
The ratio divides Operating Income (income before interest and taxes) by interest
expense.
Analysts typically require minimum ratios of four to qualify for strong credit ratings.
The Software Industry generally has very high profit margins and low debt, creating very
high coverage ratios. The retail industry, on the other hand, has lower profit margins than
software, resulting in less Operating Income to cover interest expenses.
4. Leverage Ratio = Assets/Owner's Equity
The higher this ratio is, the higher the debt. Generally, ratios of higher than 15 are a
warning signal, while low ratios may indicate underutilized assets. It is a handy tool
because it captures all liabilities regardless of where they are listed.
The company either owns an asset (Assets = Owner's Equity) or financed part or all of it
(Assets - Liabilities = Owner's Equity).
For example, if the owner invests $50,000 to start a business in cash, the ratio = 1, as 50
000/50 000 = 1. If the company then purchases machinery for $500,000 on loan, the
Leverage Ratio becomes 11, as 550,000/50,000 = 11. If the business owns $50,000 of the
total assets of $550,000, the total debt must equal 500,000.
To add relevance to this number, compare the ratio with competitors and industry
averages. For example, capital-intensive industries like auto manufacturers have much
higher ratios, while the software industry, which requires much less capital investment,
has lower debt ratios.
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