Analysis, Commitments, Alternative Financing Arrangements, Leases, and Fair Value Measurements
Careful analysis is essential in making judgments about an entity's financial health. One form of analysis is ratio analysis where certain key metrics are evaluated against one another. One such ratio is "debt to total assets." This ratio shows the percentage of total capitalization that is provided by the creditors of a business:
Debt to Total Assets Ratio = Total Debt/Total Assets
A related ratio would be "debt to equity" that divides total debt by total equity:
Debt to Equity Ratio = Total Debt/Total Equity
The debt to asset and debt to equity ratios are carefully monitored by investors, creditors, and analysts. The ratios are often seen as signs of financial strength when "small," or signs of vulnerability when "large." Of course, small and large are relative terms. Some industries, like the utilities, are inherently dependent on debt financing but may, nevertheless, be very healthy. On the other hand, some high-tech companies may have little or no debt but be seen as vulnerable due to their intangible assets with potentially fleeting value. In short, one must be careful to correctly interpret a company's debt related ratios. One must also be careful to recognize the signals and trends that may be revealed by careful monitoring of these ratios.
Another ratio is the "times interest earned ratio:"
Times Interest Earned Ratio Income Before Income Taxes and Interest/Interest Charges
This ratio is intended to demonstrate how many times over the income of the company is capable of covering its unavoidable interest obligation. If this number is relatively small, it may signal that the company is on the verge of not generating sufficient operating results to cover its mandatory interest obligation.
There are numerous other ratios that can be described; in fact, many of these are covered in other chapters (along with mathematical illustrations). However, while ratio analysis is an important part of evaluating a company's financial health, one cannot be too careful or place undue reliance on any single evaluative measure. This will become quite apparent as you read the final concluding comments below.
Contractual Commitments and Alternative Financing Arrangements
A company may enter into a long-term agreement to buy a certain quantity of supplies from another company, agree to make periodic payments under a lease (or similar arrangement) for many years to come, agree to deliver products at fixed prices in the future, and so forth. There is effectively no limit or boundary on the nature of these commitments and agreements. Oftentimes, such situations do not result in a presently recorded obligation, but may give rise to an obligation in the future. This introduces a myriad of accounting issues that are beyond the scope of introductory accounting courses, but a few generalizations are in order. First, footnote disclosures are generally required for the aggregate amount of committed payments that must be made in the future (with a year by year breakdown). Second, changes in the value of such commitments may entail loss recognition when a company finds itself locked into a future transaction that will have negative economic effects (e.g., committing to buy oil at $80 per barrel when the current price has declined to $65). From these observations, one thing should be clear to you - beware to not limit your evaluation of a company to just the numbers on the balance sheet, as significant other financial details are often found in notes to the financial statements.