Saturday, December 4, 2010

Debt or Leveraging Ratios




Debt Ratios measure the company’s ability to repay its long-term debt commitments. They are used to calculate the company’s financial leverage. Leverage refers to the amount of money borrowed in order to maintain the stable/steady operation of the organization.

The Ratios that fall under this category are:

1. Debt Ratio
2. Debt to Equity Ratio
3. Interest Coverage Ratio
4. Debt Service Coverage Ratio

Debt Ratio:

Debt Ratio is a ratio that indicates the percentage of a company’s assets that are provided through debt. Companies try to maintain this ratio to be as low as possible because a higher debt ratio means that there is a greater risk associated with its operation.

Formula:

Debt Ratio = Total Liability / Total Assets

Debt to Equity Ratio:

This ratio is used to identify the financial leverage of the company i.e. to identify the degree to which the firm’s activities are funded by the owners money versus the money borrowed from creditors.

The higher a company’s degree of leverage, the more the company is considered risky.

Formula:

DER = Net Debt / Equity

Note: This is the same as the Gearing Ratio that was discussed in Efficiency Ratios

Interest Coverage Ratio:

This ratio is used to determine how easily a company can repay the interest outstanding on its debt commitments. The lower the ratio, the more the company is burdened by debt commitments. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet its interest expenses becomes questionable. An interest coverage ratio of < 1 indicates that the company is not generating sufficient revenue to satisfy its interest expenses. Formula:

ICR = EBIT / Interest Expenses

EBIT – Earnings Before Interest and Taxes

Debt Service Coverage Ratio:

DSCR is similar to the other debt ratios. This is a measure of the amount of cash flow available with the company to meet its annual interest and principal payments on its debt obligations. A DSCR of less than 1 means a negative cash flow. i.e., the company is not generating enough cash flow to meet its debt obligations. Company's try to keep their DSCR to be a value much higher than 1.

Formula:

DSCR = Net Operating Income / Total Debt Service

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