Financial Covenants

Measuring a company’s financial health can be analysed by:


Profitability is the extent to which a business experiences profits and financial gains. It measures the success of a business. In the short run, firms can survive without profitability by operating on the goodwill of creditors and investors. In the long run, firms must inevitably become profitable. It is the amount of income generated for the owners.


Gross Margin

Interprets how much is remaining to pay for overheads etc. It shows how much profit a company makes after paying off its Cost of Goods Sold (COGS). If there is no positive gross margin, then it is not even worth calculating the net margin. The ratio indicates the percentage of each dollar of revenue that the company retains as gross profit.

= Gross Income / Revenue


Net (profit) Margin

Net margin measures the amount of net profit a company obtains per dollar of revenue gained. It measures the % of dollars remaining from the revenue after deducting all expenses, except for taxes. It demonstrates the ability of the company to generate surplus cash. Net margin will vary dependent on the industry (so it is worth to compare relative to its peers.

=Net Income / Revenue


Operating margin

Operating Profit Margin differs from Net Profit Margin as a measure of a company’s ability to be profitable. The difference is that the former is based solely on its operations by excluding the financing cost of interest payments and taxes.

=operating profit / revenue


Return on assets (ROA):

indicates how effectively the company is deploying its assets. A very low return on asset, usually indicates inefficient management, whereas a high ROA means efficient management.

=Net Income/Total Assets


Return on Investment (ROI)

Measures a firm’s profitability relative to the amount of capital invested to generate that profitability.

= Net Income / Total Investment


What is Return on Equity (ROE)

The number represents the total return on equity capital and shows the firm’s ability to turn assets into profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.

=Net income / Shareholders’ Equity



Liquidity is how much cash does the firm hold. Basically, how quickly can it pay back its short term debt obligations. In other words, they relate to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities.


Current Ratio

Also known as the working capital ratio. Measures the ability of an entity to pay its near-term obligations. "Current" usually is defined as within one year. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business.

=current assets / current liabilities


Quick Ratio (= acid test ratio)

equal to current but only of the most recent assets and liabilities. More conservative as it regards at the moment. Provides a stricter definition of the company's ability to make payments on current obligations. This provides a more realistic indication of a company’s ability to handle short-term obligations based on their available cash and assets. In other words, the acid-test ratio is a measure of how well a company can satisfy its short-term (current) financial obligations.


Cash Ratio

Sometimes referred to as the cash asset ratio, indicates a company’s capacity to pay off short-term debt obligations with its cash and cash equivalents. Compared to other liquidity ratios such as the current ratio and quick ratio, the cash ratio is a stricter, more conservative measure because only cash and cash equivalents – a company’s most liquid assets – are used in the calculation.

=Cash / Liabilities


Cash to Total Assets

Slightly less relevant. Measures the portion of a company's assets held in cash or marketable securities. Although a high ratio may indicate some degree of safety from a creditor's viewpoint, excess amounts of cash may be viewed as inefficient.

= Cash / Total Assets



Solvency (=Leverage)

Closely related to liquidity is the concept of solvency, a company's ability to meet its debt obligations on an ongoing basis, not just over the short term. Leverage ratios look at the extent to which a company has depended upon borrowing to finance its operations. A high leverage ratio may increase a company's exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns.


Debt to equity ratio (or leverage ratio)

In general, debt should be between 50 and 80 percent of equity. It only considers shareholder equity, and not total assets of a company. It illustrates how a company’s capital structure it tilted toward debt or equity and their appetite to risk.

A low or high ratio can both be good or bad. A low ratio is good as it means more money from stakeholders and less from creditors and it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn although it will mean lower potential equity returns. A high debt-equity ratio can be good because it shows that a firm can easily service its debt obligations (through cash flow) and is using the leverage to increase equity returns but runs the risk of not being able to pay its debt in difficult times.

= company liability / shareholder equity


Debt Ratio (=Debt to Asset)

Measures the percentage of assets being financed by liabilities. The debt to asset ratio is commonly used by creditors to determine the amount of debt in a company, the ability to repay its debt, and whether additional loans will be extended to the company. On the other hand, investors use the ratio to make sure the company is solvent, is able to meet current and future obligations, and can generate a return on their investment. Companies with a higher ratio are more leveraged and hence, riskier to invest in and provide loans to. If the ratio steadily increases, it could indicate a default at some point in the future. The ratio must be less than 1 (otherwise is technically seen as bankrupt).

= Total Liabilities / Total Assets


Interest coverage: indicates how comfortably the company can handle its interest payments. In general, a higher interest coverage ratio means that the business is able to take on additional debt.

= Earnings before Interest and Taxes / Interest Expense


Debt Service Cover Ratio -

how easily a company can pay its debt obligations

= Operating income / Total debt service



Operating Efficiency

Defined as the ratio between an output gained from the business and an input to run a business operation. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given time period. This information can help management decide whether the company's credit terms are appropriate and whether its purchasing efforts are handled in an efficient manner.


Operating margin

measure how well a company is utilizing its assets and resources. The operating margin measures how much profit a company makes on a dollar of sales, after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating profit by its net sales. The higher the margin the more profitable the company.

=Operating Earnings / Revenue


Asset Turnover

measures the value of revenue generated by a business relative to its average total assets for a given fiscal or calendar year. It is an indicator of how efficient the company is using both the current and fixed assets to produce revenue.

= Net Sales Revenue / Average Total Assets

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