Which ratios measure financial debt and leverage?
To the general public, debt is often considered a scary term fraught with images of bankruptcy and credit cards. In business, debt is an essential partner to investment from shareholders to finance business growth. If a company spots an opportunity in the market and needs money to go after it, they need to source this from creditors and investors. However, unlike investment from investors, debt is usually taken with an agreement to pay interest on the loaned amount and with the interest comes risk. This article shows you the various financial ratios used to analyze and understand how a company structures their need for cash and tells you what to look out for that would signal a red flag. The debt and leverage ratios we explore are:
- Debt/Equity Ratio
- Net Debt
- Debt Ratio
- Debt to Capitalization Ratio
- Interest Coverage Ratio
- Cash Flow to Debt Ratio
- Equity Multiplier
1. Debt/Equity Ratio
In corporate finance, knowing your debt to equity (D/E) ratio is fundamental. This ratio describes the means of financing for any given company, debt referring to a company's total liabilities, and equity referring to a company's shareholders equity. The purpose of this formula is to get a number that reflects how much of a company's equity can cover its debt. As such, a higher D
Debt/Equity Ratio = Total Liabilities / Total shareholders Equities
2. Net Debt
The net debt calculation illustrates a company's ability to pay off all of its debts if they were to be paid today. This Formula gives us an insight into a company’s liquidity, as it takes into account all debt amounts from the balance sheet, and assets that can be converted into cash quickly (ie. highly liquid assets).
Net Debt = (Short Term Debt + Long Term Debt) - Cash and Cash Equivalents
3. Debt Ratio
The debt ratio compares a company’s debt to its assets. It can be thought of as representing the proportion of assets that are financed through debt. In doing so, it allows us to further understand a company’s financial leverage. Similar to the D/E ratio, a higher Debt ratio indicates a larger financial risk. If a company has a Debt ratio above 1 it tells us that they have more debt than assets which could cause serious issues should interest rates rise. However, as with all financial ratios it is always important to compare a company’s ratio to the industry average. In this case, asset heavy industries (such as utilities) will have a higher Debt ratio.
Debt Ratio = Total Debt / Total Assets
4. Debt to Capitalization Ratio
The Debt to Capitalization (Often just called the capitalization ratio) ratio gives us insight into how a company’s capital is structured. It’s another leverage ratio that gives us insight into the financial backing of a company. Capital is the total value of a firm’s debt and equity. This ratio compares the value of long and short term debt against total debt plus total shareholder’s equity. A higher Capitalization ratio tells us that a firm uses more debt to finance business operations than money invested by shareholders, and is therefore of higher financial risk. Looking at how debt compares to debt plus shareholder’s equity is a better approach than looking at the absolute value of debt. $25 million of debt in a company with $10 million worth of shareholder’s equity would be a red flag, but the same amount of debt in a company with $100 million worth of shareholder’s equity would be of less concern.
Debt to Capitalization = Total Short & Long term Debt / (Total Short & Long Term Debt + Shareholders Equity)
5. Interest Coverage Ratio
ICR is calculated by dividing the operating profit (or EBIT) by interest expense, and measures the company’s ability to pay off its interest on any loans that have been taken. ICR usually means the companies ability to pay off its interest ( repayment of interest on loan taken) obligations. More the better. A strong ICR indicates that a company can fulfil it’s interest obligations provided it has good earnings before interest and taxes. It is sometimes known as “times interest earned” and is used by investors and creditors to determine financial risk. A higher ICR is considered a stronger value because it means a company is more able to service its debt. However, the ideal ICR will vary by industry and you should compare a firm’s ICR to the industry average.
Interest Coverage Ratio = Earning Before Tax & Interest / Interest Expense
6. Cash Flow to Debt Ratio
The Cash Flow to Debt (CFD) ratio is another ratio that looks at a company’s leverage. Essentially, the CFD ratio tells us how long it would take to repay all debt if the company's operating cash flows were all directed towards this purpose. Operating Cash Flow is typically used when calculating this ratio, though some analysts use unlevered cash flow as well. Financing cash flow isn’t included because it wouldn’t make sense (nor would it be smart) to borrow money (financing cash flow) to pay off debt. Investing cash flow isn’t included since its not a part of the day-to-day business activities. Once more, a higher figure is a better one since it means a firm is more able to repay its debts.
Cash Flow to Debt Ratio = Operating Cash Flow / Total Debt
7. Company Equity Multiplier
The Equity Multiplier ratio is the only featured leverage ratio that doesn’t include debt or liabilities. This financial leverage ratio is useful in determining the proportion of assets financed by equity. It can be thought of as the perfect partner for the debt ratio. If the Equity Multiplier is high then it means the company’s assets were primarily funded by debt and hence it is more subject to financial risk. In essence, the company’s shareholders have invested less into the company than creditors. So clearly, a lower Equity Multiplier is what we want to see relative to the industry average.
Equity Multiplier = Total Assets / Total Shareholder’s Equity
Debt requires two parties, the borrower and the lender. The lender lends the borrower money, and the borrower promises to repay that debt, plus all interest that was specified in their agreement, by some specified date. Debt is a simple concept, but a tricky thing to use if you aren’t wise with your decisions. Finance is full of estimates and risks, but making sure those estimates and risks are calculated will give you the best chance at financial success. Calculating the full spectrum of debt/leverage ratios will enable you to get a solid understanding of the company’s risk and their financing strategy to see if it aligns with what you look for in a company.