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There have been many organizations which were profitable and don't exist anymore because it is not enough that the organization is profitable. It is equally important that it is stable.
In the earlier session on ratio analysis, I
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gave you a few profitability ratios that can be worked out. Today, let me talk about the stability ratios.
The data for these ratios comes from the balance sheet. These ratios are either called
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financial ratios or stability ratios. And since the data comes from a balance sheet, let me show you a balance sheet.
Now, here's a balance sheet. It tells you the share capital of this company is 200.
The reserves are 100. So, the
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shareholders equity, the net worth is 300. Against 300 they have long-term loans of 600 and current liabilities of 100.
Total of the liability side is 1,000. Where did this money go?
Right hand side
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tells you 600 has been invested in fixed assets the infrastructure and 400 has gone into working capital. Three components of working capital are inventory, debtors and bank balance.
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Now let's work out a few stability ratios. The first ratio and a very important one is called current ratio.
I'll give you the alternate names for these also. Current ratios are also called working capital ratio or solency
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ratio. You know healthy current ratio is 2 is to1.
So it's also called the 2 is to1 ratio. The norm is incorporated in the name itself.
What is the formula for a current ratio? Current assets by current liabilities.
How much are the
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current assets of this company? 400.
What kind of current liabilities do they have? 100.
How much is the current ratio? 4 is to1.
Ideal current ratio is 2 is to1. Guys, if you're running a business, you would do well if you
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monitor this ratio continuously. Try and not let it go out of hand.
along with the next ratio. These two ratios will determine the long-term existence of your organization.
The next ratio is called liquidity ratio. Alternate names
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are it is also called quick ratio. It is also called acid test ratio.
That important it is or the norm is healthy liquidity ratio is 1 is to1. So it's also called the 1 is to1 ratio.
This
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ratio said not only it's important that your current assets are two times your current liabilities you know current ratio 2 is to1 but out of those two of current assets when this one of liabilities come demanding for their money return our money back those all three items of current assets cannot be
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liquidated at will which are the three components of current assets inventory debtors and bank balance bank balance is already liquid debtors also have a meter running. You know if your customer said 60 days
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credit period now you know if not 60 experience shows 65 70 days the money comes in. So there's a time frame attached to it but inventory is what is known as an illlquid asset.
You made the product it's sitting in your warehouse
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but you don't know when a customer will walk in and buy it. You may not get a customer for a long time particularly if the product is a high value product.
You could be a builder. You've constructed a building.
Out of the 50 apartments you've made, maybe there are 20 30 lying
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unsold. You don't know when a customer will come in.
So you cannot make any commitment against that. So your current assets can be broken up into liquid current assets which is a combination of cash plus debtors and inventory.
And if
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you ignore the inventory, the ratio of liquid current assets to current liabilities is called the liquidity ratio or the quick ratio. And this should be minimum 1 is to1.
So guys, what should be the formula? Pretty simple, all very logical.
It is liquid
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assets upon current liabilities. Liquid assets are current assets minus inventory.
In this case, if you exclude the inventory, then the liquid assets are 280 against current liabilities of 100. So
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the ratio is 2.8 is to1. Ideal ratio is 1 is to1.
Then there is a ratio called proprietary ratio. How much money have the owners invested in this company?
Proprietors investment is represented by
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capital plus reserves. owners have invested 300.
And how much is the total of asset side of this balance sheet? It's a,000.
In other words, out of a total assets of,000 that this company possesses, 300 has been funded by the
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owners. So the proprietary ratio is 30% or.3.
Tell me who is happy when the proprietary ratio is high? Obviously the lender outside lenders the bankers you
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know there's a phrase in banking parlance which says skin in the game bankers love it when the owners have more skin in the game. Higher the proprietary ratio greater the owner skin in the game and that makes the banker
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relatively more comfortable. Then there's a ratio called debt equity ratio.
Guys remember always in the debt equity ratio debt is in the numerator. Tell me how much is the debt of this company?
600.
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And how much is the equity of this company? 300.
So what kind of debt equity ratio does this company have? They have a debt to equity ratio of 2 is to1.
I always felt you don't bother about this ratio. Let the bankers worry
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about it. These are for banking norms.
Banks have norms that you know smallcale units will be eligible for a maximum debt equity ratio of 3 is to1. That means if the owners have invested one we will lend them up to three.
Mediumcale
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companies are eligible for debt equity 2 is to1. Large scale companies 1 is to1.
So if this balance sheet happens to be of a small scale company where the debt equity eligibility is 3 is to1. How much is the equity of this owners of this
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company? 300.
With the 3 is to1 ratio that they are eligible to borrow up to 900. How much have they borrowed?
600. In case they need another 300 and assuming it falls into the parameters of the bank, lending parameters of the
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bank, then chances are they can get a loan of another 300. But if this happen to be a medium-scale company where they are eligible for debt equity 2 is to1 then against 300 they can borrow 600 they've already borrowed 600 they have exhausted their debt equity ratio if
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this company needs another 300 and they approach a bank the banker will most likely say will ask the owners I suggest you contribute further capital of 100 that will take your equity from 300 to
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400 00 against 400 I can lend you 800 out of 800 I have lent you 600 so I can lend you another 200 but I've always said let the bankers worry about this my philosophy is debt is not bad wrong debt
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is bad unproductive debt is bad debt which violates my two golden rules that is bad but if your two golden rules are not violated what are the two golden rules Number one, make sure when you take a loan, you
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are committed to service it. You're supposed to pay an interest on it.
And when you take a loan, you deploy it somewhere. Can you earn greater than what you have to pay?
Not enough. The when you take a loan from a bank, it has to be repaid.
There's a
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repayment schedule. But when you invest in assets, those assets can help you generate an inflow.
It is important that the assets will bring a cash inflow before the liabilities demand and
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outflow. Guys, if these two rules are not violated, the more you borrow, the more you will prosper.
So this ratio debt equity is not for you to say I will not borrow anymore because I've exhausted my debt equity ratio. You don't have a debt equity ratio.
It's for the banker. Let that fellow decide I
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will not lend you anymore. And then there's a ratio called repayment coverage ratio.
Guys, when a when you go to a bank to ask for a loan, the banker is concerned about two things. Number one, is the borrower capable of servicing the loan, paying interest on
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the loan? I had covered this ratio when I talked to you about profitability ratios.
What is required in order to be able to pay the interest on the loan? Remember the relevant numerator for interest coverage ratio is PBIT profit before interest and
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tax. From the sales revenue that the company generates, you will first pay all the operating expenses.
What is left is called operating profit which is also called PBIT. Profit before interest and tax.
Then from the PBIT you pay the
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interest. So for the for this for the interest coverage ratio the relevant numerator is PBIT and you compare the PBIT with the interest payable and if that is a positive number and a relatively high number then the banker feels comfortable but the banker not
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only wants you to pay interest the banker also wants to know can this borrower afford to return the loan the principal component and therefore the second ratio that the banker will calculate is the repayment coverage ratio that comes under stability ratios.
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Now guys, I want you to guess the formula. You know the best part is don't remember these formula.
Understand, get under under the skin of these formula. Get under the skin of the ratio.
You'll be able to create the formula yourself. Then you don't need to remember anymore.
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Now what is this ratio? Repayment coverage ratio.
First of all, what does coverage ratio mean? Coverage ratio just talks about how many times are you covered.
Guys, if I owe you a 100 bucks and I have only a 100 B, my earning ability is
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100, then you're covered one time. That makes it a little risky that if I don't earn that one, if I earn less than one, you won't get your money.
But if I owe you one and if I earn two, then you're covered two times. Then even if instead
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of two I earn one and a half, you may still get your money back. But if I earn five, you are covered five times.
Higher the coverage ratio, greater the probability that you will get what you are hoping to get. So this is the repayment coverage ratio.
Banker wants
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to know how many times am I covered so far as repayment is concerned. So I want you to guess guys.
Keep your thinking caps on while I'm talking. Don't just let it be a one-way thing.
What what should be the numerator and the denominator? You want to know you are a
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banker now. Wear the hat of a banker.
You want to know can this borrower return my money and how many times am I covered? What will you compare with what?
What do you need in order to return the loan? Not profit.
Remember profit is not money as it is. You want to know the
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money available to return the loan? You need hard cash.
So you will look at the cash flow funds available. And what will you compare the funds available with?
Can this guy afford to pay the loan? So what will you compare it with?
not the loan amount, not the entire loan amount.
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You're going to compare it this year's fund flow with this year's installment due. So now you have the formula, guys.
When you create the formula like this, you don't need to remember it anymore. So the formula for repayment coverage ratio would be available funds for
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repayment of long-term debts and compare it with the loan installments due within a year. And if this ratio is positive, maybe two, maybe three and the interest coverage ratio maybe five, six, then the banker feels a sense of comfort.
Guys,
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these were a few stability ratios that I wanted to share with you. I've covered profitability ratios earlier.
These are the stability ratios. If you like this video, do share, subscribe, like.
The third category of ratios is the efficiency
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ratios. very very important.
Those are there at our membersonly section guys. And if you want to learn more about finance, do explore that section.
Do consider joining it and I will see you there.