Debt ratios
/What are Debt Ratios?
Debt ratios measure the extent to which an organization uses debt to fund its operations. They can also be used to study an entity’s ability to pay for that debt. These ratios are important to investors , whose equity investments in a business could be put at risk if the debt level is too high. Lenders are also avid users of these ratios, to determine the extent to which loaned funds could be at risk. Debt ratios are a particular concern when a business wants a credit rating agency to give a rating to one of its debt securities ; if the ratios reveal a high debt load, a rating agency may assign a low rating that increases the interest cost of the securities to be sold. The key debt ratios are noted below.
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The Interpretation of Financial Statements
Debt to Equity Ratio
The debt to equity ratio is calculated by dividing the total amount of debt by the total amount of equity. The intent is to see if funding is coming from a reasonable proportion of debt. Lenders like to see a large equity stake in a business. The formula is as follows:
(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio
Debt Ratio
The debt ratio is calculated by dividing total debt by total assets . A high ratio implies that assets are being financed primarily with debt, rather than equity, and is considered to be a risky approach to financing. The formula is:
Total debt ÷ Total assets = Debt ratio
A variation on the debt formula is to add all liabilities to the numerator, including accounts payable and accrued expenses .
Debt Service Coverage Ratio
The debt service coverage ratio is calculated by dividing total net annual operating income by the total of annual debt payments. This measures the ability of a business to pay back both the principal and interest portions of its debt. The formula is as follows:
Net annual operating income ÷ Total of annual loan payments = Debt service coverage ratio
For more accuracy, reduce the total debt service figure by the beneficial effect of the deductibility of interest payments on income taxes .
Interest Coverage Ratio
The interest coverage ratio is calculated by dividing earnings before interest and taxes by interest expense . The intent is to see if a business can at least pay for its interest payments when due, even if the balance of a loan cannot be repaid. This measure works well in cases where a loan is expected to be rolled over into a new loan when it reaches maturity . The calculation is as follows:
Earnings before interest and taxes ÷ Interest expense = Interest coverage ratio
Trend Line Analysis
It is useful to plot these measurements on a trend line . Doing so reveals the existence of any issues where the debt load of an entity is increasing over time, or where its ability to repay debt is declining.
