## Debt Ratios

Debt ratios are financial ratios that compare a company’s total debt to its assets or equity. They’re used by investors, creditors, and analysts to assess a company’s financial leverage and its ability to repay its debts, which are key indicators of financial risk. There are several types of debt ratios, including:

**Debt Ratio:**This measures the proportion of a company’s total debt to its total assets. It’s calculated as total debt divided by total assets. A higher ratio indicates a higher level of debt in relation to assets, which can signify greater financial risk.**Debt-to-Equity Ratio (D/E):**This measures the financial leverage of a company by comparing its total liabilities to shareholders’ equity. It’s calculated as total debt divided by total equity. A higher D/E ratio means that a company has been aggressive in financing its growth with debt, which can result in volatile earnings.**long-term debt to Equity Ratio:**This is similar to the D/E ratio, but it only considers long-term debt (debt that is due more than a year out). It’s calculated as long-term debt divided by total equity. This ratio gives a clearer picture of a company’s long-term solvency and risk.**Times Interest Earned Ratio (or Interest Coverage Ratio):**This measures a company’s ability to meet its debt obligations. It’s calculated as earnings before interest and taxes (EBIT) divided by interest expenses. A higher ratio indicates a greater ability to cover interest payments, which is a positive sign for creditors and investors.

Each of these ratios provides a different perspective on a company’s debt and its financial risk. They’re often used together to get a comprehensive view of a company’s financial health. As with all financial ratios, debt ratios should be used in comparison with other companies in the same industry for a meaningful analysis.

## Example of Debt Ratios

Let’s consider a hypothetical company “ABC Corporation” with the following financial data:

- Total Debt (both current and long-term): $200,000
- Total Assets: $500,000
- Total Equity: $300,000
- Long-term Debt: $150,000
- Earnings Before Interest and Taxes (EBIT): $80,000
- Interest Expense: $20,000

We can use this data to calculate various debt ratios:

**Debt Ratio:**

\(\text{Debt Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}} = \frac{\$200,000}{\$500,000} = \text{0.4 or 40%} \)

This means that 40% of the company’s assets are financed by debt.**Debt-to-Equity Ratio (D/E):**

\(\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}} = \frac{\$200,000}{\$300,000} = \text{0.67} \)

For every dollar of equity, ABC Corporation has $0.67 in debt.**Long-Term Debt to Equity Ratio:**

\(\text{Long-Term Debt to Equity Ratio} = \frac{\text{Long-term Debt}}{\text{Total Equity}} = \frac{\$150,000}{\$300,000} = \text{0.5} \)

This means for every dollar of equity, ABC Corporation has $0.50 in long-term debt.**Times Interest Earned Ratio (or Interest Coverage Ratio):**

\(\text{Times Interest Earned Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}} = \frac{\$80,000}{\$20,000} = \text{4 times} \)

ABC Corporation can cover its interest expense 4 times with its earnings before interest and taxes.

These ratios collectively provide a snapshot of ABC Corporation’s leverage and its ability to meet its debt obligations. While the Debt Ratio and Debt-to-Equity Ratio provide insights into the company’s capital structure, the Interest Coverage Ratio provides a sense of how comfortably the company can handle its interest payments. It’s important to compare these ratios with industry peers for a more meaningful analysis.