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So by raising debt the financial risk of the shareholders increases and as a result there is a change in the overall systematic risk of the firm which is represented by the Beta, Is my thought correct?
Thank you John for making me aware about this. I am new to this portal I had created my profile yesterday I saw some interesting posts where i thought i could help out on things which I am well versed with. I am presently a student from the Institute of Cost Accountants of India and pursuing my final level . I have plans of taking up ACCA in near future. Can I post questions on this portal without being a student of ACCA?. I firmly believe that exchanging knowledge is the best way for learning.
Thank you John, This was very helpful know I have a better conceptual clarity now.
Sorry Izzuan, I am late to reply to your post, the reason of debt beta being zero is that Interest on debt capital doesn’t vary for example when a company issues debt for its expansion project it has to pay interest to the debenture holders yearly at a fixed rate and this rate doesn’t change irrespective of Economic conditions therefore there is no volatility in the interest rate and when there is no volatility obviously the risk which is calculated in quantitative terms which is called as Standard deviation is Zero. Since beta is also a measure of risk even the beta tends to become zero. However a Company’s Equity Beta changes according to the changes in the economic conditions of the country which reflected on the Stock Index and as the company’s stock is also correlated to the Stock Index the Beta of the stock changes unless your stock is perfectly correlated with the Stock Index which is less practical. And as the beta changes Investors or the Stake holders expect their rate of returns in accordance with the changes in the beta and as a result there will be change in the Cost of Equity of the company (Ke). I am sure your well versed with the CAPM model figured out by Harry Markowitz Ke=RF+Beta(RM-RF). To conclude Debt capital cost (Kd) is not volatile and hence the debt beta is always Zero However the Cost of Equity (Ke) changes according to the Stock Index movements and hence Equity Beta varies. Hope this was helpful. Thank You:)
I am going to interpret few ratios as under first let me start with Solvency Ratios
Current Ratio= Current Assets/Current Liabilities, The current ratio indicates how quickly i can meet my current liabilities out of my current assets. if the current ratio appears to be 2:1 then it is certainly favorable for the company since my current assets are double than my current liabilities. Current ratio indicates the liquidity position of the firm or technically it determines the short term solvency of the firm. Most of the Banks in India take into account the short term solvency position of the firms before granting Working Capital Loans.
Liquid Ratio or Acid Test Ratio= Current Assets-Inventory and Prepaid Expenses/Current Liabilities. One of the serious limitations of current ratio is that the current assets includes Inventory. The inventory shown in the Balance sheet may be obsolete or blocked up due to lack of sales due to adverse economic conditions and since inventory forms substantial part of current assets your current ratio may look very favorable and it may indicate a fictitious or artificial favorable short term solvency of the firm. As a result an accurate version of this ratio is Liquid Ratio which eliminates inventory and prepaid expenses. Prepaid expenses are deducted from the current assets because it pertains to future accounting periods and even though it is an asset it is not held as cash in a materialized form. Therefore Liquid Ratio is accurate measure of Short term solvency position of a firm.
Operating Profit Ratio= Net Profit+Non operating Expenses-Non operating Incomes/SalesX100. Operating profit ratio which is measured in terms of percentage is an Indirect measure of efficiency of the firm. The higher the operating profit ratio the better is the Core business of the firm. Core business/Core competence refers to the activities that the companies carry on, on a day to day basis to earn profit out of it. For example Ford Ltd manufactures cars it earns its profit by selling its cars manufactured which is called as an operating profit. The Key difference between Operating profit and Non Operating profit can be explained by continuing with the example of Ford Ltd as mentioned earlier Ford Ltd earns profit by selling its cars besides it may also earn profit by way of selling its old plant or machinery which is used in the business it may also earn dividends by making investments in other companies. Now the profits generated by Ford Ltd by selling its plant and investments is outside the scope of its core business and as a result it is a non operating item. The net profit which is shown in the Income statement of the company includes both operating profit as well as non operating profit. It is always important for an investor analyzing the financial statements to take a look at the operating profit ratio if the operating profit ratio is too low it may indicate the company is not concentrating on its core competencies and it may be an adverse prediction for the future survival and growth of the company. Therefore we can conclude from the above discussion that merely because a company as high profits doesn’t mean that the Company is doing well segregation of operating profits and non operating profits is very important to find out whether the company is focusing on its core competencies or the mission or the object for which it is formed.
These are 3 Important Solvency Ratios. There are lot of Ratios to be discussed such as Turnover Ratios,Long Term Solvency Ratios, Capital Structure Ratios, etc Please keep visiting this post I shall explain the other ones in few days time. Please post your doubts so that I can answer them. Thank You:)
