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The debt-to-equity ratio is evaluated relative to the industry in question and to the customary
volatility of earnings in that industry. For example, a debt-to-equity ratio of 80% would be considered
conservative in banking (where leverage is customarily above 80%), but would be regarded as
extremely risky for toy manufacturing or designer apparel (where earnings are volatile). The wellknown
“junk bonds” are an example of long-term debt securities where leverage is considered too
high in relation to earnings volatility. It is the increased risk associated with junk bonds that explains
their higher interest yields. This illustrates the general financial principle that the greater the risk, the
higher the expected return.
In summary, the two ratios used to assess long-term solvency are:
1. Interest coverage.
2. Long-term debt to equity.
Next, we consider the ratios for analyzing profitability.
Profitability
Profitability is the lifeblood of a business. Businesses that earn incomes can survive, grow, and
prosper. Businesses that incur losses cannot stay in operation, and will last only until their cash runs
out. Therefore, in order to assess business viability, it is important to analyze profitability.
Analyzing profitability is usually done in two phases, which are:
• Profitability in relation to sales.
• Profitability in relation to investment.
Profitability in Relation to Sales
The analysis of profitability in relation to sales recognizes the fact that:
or, rearranging terms:
Income = Sales - Expenses
Sales = Expenses + Income
Therefore, expenses and income are measured in relation to their sum total, which is sales. The
expenses, in turn, may be broken down by line item. As an example, we use the Chapter 1 Nutrimin
income statement for the first year of operation, along with its statements for the second and third
years.