Using Debt-Related Financial Ratios

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  • 0:01 What Is Debt?
  • 0:54 Debt Ratio
  • 2:36 Debt Service Coverage Ratio
  • 4:09 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, you'll learn about two types of ratios: debt and debt service coverage. We'll also discuss which financial statements you'll use to find the data and how to analyze the results.

What Is Debt?

Jan's Upscale Resale is a clothing store that sells gently used ladies clothing. Jan would like to expand by opening another store. She visits US Bank & Trust to see if she can get a business loan. She meets with Mark, a loan officer at the bank, and submits the business' financial statements.

After Mark reviews the information, he tells Jan she's too far in debt to afford a second location. Mark goes on to say there are several ratios that he uses to determine if a business is eligible for financing. One of them is the debt ratio, which shows the percentage of assets financed with debt. The other is the debt service coverage ratio, which measures a company's ability to make their current debt payments.

For the remainder of this lesson, you'll learn which financial statement to use to find the line items to calculate the debt ratios and formula. We'll also discuss how to analyze the results.

Debt Ratio

Jan arrogantly tells Mark that her resale store was voted the #1 resale shop in the city. She tells him she has more customers than many regionally-owned stores, so it doesn't make sense that she can't get a loan.

Mark asks Jan if she has a few minutes so he can explain the debt ratios that he calculated for her business. Jan says, 'Of course, let's get started.' Mark starts by explaining the components of a balance sheet, which are assets and liabilities.

Assets are items owned by her business. Examples include cash, inventory, the building, and cars. Liabilities are obligations she owes, an example could be a loan for the building. Liabilities and the word 'debt' are used interchangeably and mean the same thing.

Mark goes on to tell her the debt ratio is calculated by taking total liabilities divided by total assets. Both amounts can be found on the balance sheet. Mark pulls out Jan's business balance sheet and shows her she has total liabilities of $200,000 and total assets of $250,000, which results in a debt ratio of 80%. In sum, 80% of her assets are financed with loans. She still has not paid off the building her store is located in or the cars she and her employees drive around the city for business.

Mark tells Jan the bank does not make loans to businesses with debt ratios greater than 40%. He suggests she use some of her profit to pay down her debt. Jan asks Mark hastily, 'You used one ratio to determine whether to give my business a loan?' Mark replies, 'No, ma'am. There is another ratio I calculated that provides more insight; it's called the debt service coverage ratio.'

Debt Service Coverage Ratio

Mark tells Jan the debt service coverage ratio is calculated by finding profit divided by debt service. The business' income statement shows profit for a specific period and the balance sheet shows debt service. Debt service refers to principal and interest payments on all loans. Jan asks Mark to explain principal and interest before he talks about the debt service coverage calculation. Mark says, 'Absolutely.'

When a business requests a loan from the bank, the bank will loan the money they requested, which is considered the principal. They'll also charge the business for borrowing money; this is called interest. When a customer repays the loans, which is usually done through monthly payments, they will pay a portion of the principal plus interest in each payment.

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