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: This is Total Debt / Total Assets = $200,000 / $500,000 = 0.4 or 40%. This means that 40% of the company’s assets are financed by debt.
- Debt-to-Equity Ratio (D/E): This is Total Debt / Total Equity = $200,000 / $300,000 = 0.67. For every dollar of equity, ABC Corporation has $0.67 in debt.
- Long-Term Debt to Equity Ratio: This is Long-term Debt / Total Equity = $150,000 / $300,000 = 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): This is EBIT / Interest Expense = $80,000 / $20,000 = 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.