Financial ratios can be a relatively easy way to assess various aspects of a company's performance. Spanning profitability, liquidity, efficiency, stability and valuation, many of these ratios are very common, and when the results of these ratios are compared to other companies in the sector, or on the same company over time, they can be a simple yet powerful tool in uncovering the underlying progress of the company against peers. This short series of tutorials will look at different types of ratios, applying them to a specific company and then showing how comparisons could be made against rival companies in order to assess relative attractiveness. This tutorial, which is the final part of the series, will look at four financial stability ratios (i.e. looking at debt and other aspects of financial gearing).

Financial ratios are most useful when comparing like-for-like companies. For these financial stability ratios we will therefore look at two companies that are very similar in terms of operation:

We can now compute these ratio versions:

This compares to

The interest cover ratio, measured as a multiple, tells an investor how many times a company's interest expense on borrowings is covered by its operating profit. Therefore, a higher multiple is better as it says that the company has more slack. In other words, a high multiple ensures that even if its operating profit declines sharply, it can still pay the interest expense on its debt, fending off any debt defaults.

We can now compute the ratio:

This compares to

The net cash transition period ratio, measured in months, essentially tells you how long it would take the company to transition to a net cash position should it cease all positive investing and financing cash flows and solely take in cash from its operating activities. A shorter period is preferable as it suggests that the net debt can be cleared more quickly, out of internally generated cash flows.

We can now compute the ratio:

This compares to

The debt-to-market cap proportion, measured as a percentage, is a very simple figure that tells you what proportion of the current market capitalisation of the company, net debt covers. This is important because of perception within the market; many investors will steer clear of companies that have net debt at more than 50% of the market capitalisation. However, this ratio is very sector-specific so make sure to make comparisons with similar companies in the sector.

So we simply need to check the market capitalisation of the company. This is a readily accessible figure from websites such as Bloomberg or many other financial websites. Alternatively, just multiply the share price of the company by the total number of shares in issue. For convenience, Marston's current market capitalisation is circa £966.5m.

We can now compute the ratio:

This compares to

Of course, to check which company is more attractive from an investing perspective we would need to check the relative valuations of each, the state of their short-term balance sheets and concepts such as free cash flow.

Financial ratios are most useful when comparing like-for-like companies. For these financial stability ratios we will therefore look at two companies that are very similar in terms of operation:

**Enterprise Inns (LSE:ETI)**and**Marston's (LSE:MARS).**Both of these companies is involved in the operating of pub chains within the UK. I will demonstrate how to calculate each of these ratios for Marston's and then compare it with the figure for Enterprise Inns. We will use the 2014 results for Marston's, which can be found here.**1.**

**Debt-to-Equity Ratio (2 versions)**

The debt-to-equity ratio, measured as a multiple, tells an investor the relative proportion of debt that a business holds, as compared to its equity. A rising debt-to-equity ratio suggests that the company is being financed out of debt, which could be worrisome. Generally speaking, a lower ratio is preferable. This cannot be calculated if the company has no debt, which is usually a good position to be in (assuming profitable). A debt-to-equity ratio over 2.0 may be considered as a potentially serious risk to an investor.

A more stringent version of this ratio is the lower one and this swaps out total debt for non-current liabilities plus any current debt. This will generate a higher resultant figure.

Click to Enlarge |

**Marston's**

**Calculation:**We start by calculating the total debt that Enterprise Inns has on its balance sheet. This will comprise both current and non-current bank borrowings. The total equity figure is also from the balance sheet. The second version needs us to find the current borrowings figure from the balance sheet. The relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute these ratio versions:

**Debt-to-Equity = (1227.5+144)/759 = 1.81 times**

**Debt-to-Equity (V2) = (1521.5+144)/759 = 2.19 times**

This compares to

**Enterprise Inns'**version 1 debt-to-equity ratio of 1.80 and a version 2 debt-to-equity ratio of 1.90. Enterprise Inns appears marginally more attractive on the version 1 of the debt-to-equity ratio, but far more attractive on the second version.

**2.**

**Interest Cover Ratio**

The interest cover ratio, measured as a multiple, tells an investor how many times a company's interest expense on borrowings is covered by its operating profit. Therefore, a higher multiple is better as it says that the company has more slack. In other words, a high multiple ensures that even if its operating profit declines sharply, it can still pay the interest expense on its debt, fending off any debt defaults.

Click to Enlarge |

**Marston's Calculation:**For this calculation we need two figures from the income statement; the operating profit and interest expense on the debt balance. As a note, we should be looking at the underlying column for Marston's. The relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute the ratio:

**Interest Cover = 156.1/73.4 = 2.13 times**

This compares to

**Enterprise Inns'**

**interest cover of 1.71. Although Enterprise Inns has a superior debt-to-equity ratio, its operating profit covers its interest payments less times over. Therefore, there is less margin of safety if there is an operating profit downturn or if interest expenses rise. Marston's has superior interest cover.**

**3. Net Cash Transition Period (NCTP)**

The net cash transition period ratio, measured in months, essentially tells you how long it would take the company to transition to a net cash position should it cease all positive investing and financing cash flows and solely take in cash from its operating activities. A shorter period is preferable as it suggests that the net debt can be cleared more quickly, out of internally generated cash flows.

Click to Enlarge |

**Marston's**

**Calculation:**This ratio requires figures from both the balance sheet and cash flow statement. The net debt figure requires calculation. To identify this you total debt (current + non-current borrowings) and subtract off the cash and cash equivalents. Equivalents may include liquid short-term investments such as bonds, for example. Be aware that if the figure you calculate is negative, then the company has net cash already hence there is no transition period. The relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute the ratio:

**First let's calculate net debt.**

**Net Debt = 144 + 1227.5 - 173.3 = 1198.2 (or £1,198.2m)**

**NCTP = (1198.2/127.8) * 12 = 113 months**

This compares to

**Enterprise Inns'**NCTP of 104 months. This is appreciably lower than that of Marston's, but still would appear to be extremely long. That is down to the industry being heavily debt-reliant, and that debt is often offset by high levels of property assets. Nevertheless, Enterprise Inns would - assuming zero future investment/disposals or cash flows from financing and assuming no change in operating cash flows - transition to a net cash position in 9 months fewer than Marston's. Therefore it is more attractive on this metric.

**4. Debt-to-Market Cap Proportion (DMCP)**

The debt-to-market cap proportion, measured as a percentage, is a very simple figure that tells you what proportion of the current market capitalisation of the company, net debt covers. This is important because of perception within the market; many investors will steer clear of companies that have net debt at more than 50% of the market capitalisation. However, this ratio is very sector-specific so make sure to make comparisons with similar companies in the sector.

**Marston's**

**Calculation:**We have already calculated the net debt figure from the previous ratio. The net debt figure we calculated was £1,198.2m.

So we simply need to check the market capitalisation of the company. This is a readily accessible figure from websites such as Bloomberg or many other financial websites. Alternatively, just multiply the share price of the company by the total number of shares in issue. For convenience, Marston's current market capitalisation is circa £966.5m.

We can now compute the ratio:

**DMCP = (1198.2/966.5) * 100% = 124.0%**

This compares to

**Enterprise Inns'**DMCP of 357.2%. These two figures are particularly high, and are again reflective of the industry having high levels of debt, but also high levels of property assets to offset these. Nevertheless, it is clear that Marston's has a far smaller debt burden (relative to the market valuation), compared to Enterprise Inns.

**Conclusion:**The financial stability comparators for Marston's and Enterprise Inns are evenly matched with each company more attractive on two ratios each. An investor may wish to prioritise the ratios in terms of importance. For example, an investor may be most concerned about the ability of the company to repay its interest expense because of fears of a Bank of England interest rate rise, leading to a likely increase the interest expense. In such a circumstance, they may prioritise the interest cover ratio, which shows Marston's as being in a much better position.

Of course, to check which company is more attractive from an investing perspective we would need to check the relative valuations of each, the state of their short-term balance sheets and concepts such as free cash flow.

**This tutorial has looked at four financial stability ratios that you can apply when conducting fundamental analysis.**