Copyright

Practical Application in Accounting: Using Debt-Related Financial Ratios

Instructor: Scott Tuning

Scott has been a faculty member in higher education for over 10 years. He holds an MBA in Management, an MA in counseling, and an M.Div. in Academic Biblical Studies.

Debt-related ratios are of paramount importance to virtually all of an organization's stakeholders because they provide a quick, accurate picture of the ability to repay loans. In this scenario, you'll apply what you know about debt ratios to a business situation.

How Debt Ratios Indicate Financial Health

There are lots of numbers, facts, and figures that help stakeholders understand an organization's financial health. Debt ratios provide a concise, accurate picture of an organization's ability to repay loans or other forms of credit. In many cases, they also indicate the degree of relative difficulty (or lack thereof) that a company will have in meeting their credit obligations.

Like any isolated data point, no singular debt ratio provides a comprehensive picture of the organization's debt health. But when taken together and interpreted accurately, debt ratios help business leaders make sound financial decisions.

Review the lesson Using Debt-Related Financial Ratios, then read the scenario below. You'll be asked to analyze some debt-related ratios and offer an accurate interpretation of them.

Scenario

Wildfire FC is a youth and adult soccer club in a suburban community. The area has seen rapid population growth, and Wildfire's enrollment has steadily increased. The rosters have grown so much that they no longer possess the facilities to accommodate all the youths and adults who want to play soccer.

The good news for Wildfire is that they own their current facility outright, so selling it to raise capital is definitely an option. The bad news is that remodeling or expanding the current facility is impossible due to the cost associated with bringing an older building up to current codes. This means that Wildfire FC is in the market for a mortgage so that they can accommodate their explosive growth.

Imagine yourself in the role of a commercial account executive at a local branch of a large bank. You will decide whether to recommend the approval of a loan to Wildfire FC. You'll also play a pivotal role in determining an interest rate (provided you decide to recommend loan approval.)

But you'll want to be sure you get this one right. Once you've determined your recommendations, you'll have to present them to the underwriter. You don't want to look foolish or uninformed when you present, and you certainly don't want the underwriters to lose faith in your ability to make solid recommendations.

Analysis: Data Gathering

In analyzing this scenario, ask yourself:

  • What data do I need to begin my analysis?

Hopefully, you identified the need to review data about Wildfire's assets, liabilities, debt ratio, and debt service coverage ratio. To calculate this important data, you request several documents from Wilfire FC. Wildfire FC responds with the data presented below.

A summary of Wildfire FC's balance sheet for the last two years looks like this (in thousands):

2017
Total Assets 20,756
Total Liabilities 6,452
Shareholder Equity 26,098

Wildfire's income and interest data is as follows:

2017
Earnings Before Interest and Taxes (EBIT) 9,652
Interest Expense 3,263

Calculate the Debt Ratio

  • With this information, how would you calculate Wildfire's debt ratio?

A debt ratio is calculated by dividing total liabilities by total assets. With this formula in mind, Wildfire's debt ratio in 2017 was just under 32%.

  • How do you feel about this ratio in terms of loan approval?

You (and your underwriters) should feel very good about this ratio. In a nutshell, this ratio means that Wildfire is not inundated by debt, and that the organization likely has the financial capacity to increase its debt.

Calculate the Debt-to-Equity Ratio

  • Using the information provided, how will you calculate Wildfire's debt-to-equity ratio?

To unlock this lesson you must be a Study.com Member.
Create your account

Register to view this lesson

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Try it risk-free for 30 days

Earning College Credit

Did you know… We have over 160 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Try it risk-free for 30 days!
Create An Account
Support