Investing 101

Solvency ratios focus on a company’s ability to meet its long term obligations such as debt. The amount and type of debt a company holds will influence their future risk and return. This measure is known as leverage and there are 2 kinds. Operating leverage comes from fixed costs like building rent and financial leverage arises from financing costs like interest expenses.

A commonly used measure is the debt-capital ratio which measures what percentage of a company’s total capital is financed by debt.

Debt-to-Capital Ratio = Total DebtTotal Debt + Shareholder's Equity

On the financial leverage side, the interest coverage ratio (aka Times Earned Ratio) represents how many times earnings before interest and taxes (EBIT) can cover the interest payments.

Interest Coverage = EBIT/Interest Payment

The amount and type of debt a company holds influences their future risk and return.

Solvency

Fundamental Valuation Ratios

The profitability of a publicly traded company drives the value of its equity as investors primarily care about the profits their investments generate. For example, the most common ratio is the Net Profit Margin - of the revenue generated, how much is profits? Additionally, Return on Investment measures the amount of profit made on an investment. Both these ratios are important for investors prior to investing because they can understand the profitability of a company or the cost structure (the inverse of profit).

Additionally, profitability ratios can be used to understand what percentage of the revenue is available to cover expenses. This is calculated using the Gross Profit Margin, which looks at how much money is generated to cover expenses after the cost of goods are subtracted from the revenue.

Net Profit Margin =Net Income/Revenue

Return on Investment = Profit/Investment

Gross Profit Margin = Gross Profit/Revenue

_You can find these values on the company’s balance sheet/income statement_

Profitability

Solvency