# What are Debt Ratios? ## 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: 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.

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