Deborah teaches college Accounting and has a master's degree in Educational Technology.
Financial analysis is a tool used by potential investors to assess investments they're considering. In this lesson, you will learn about financial ratios that can be used to assess debt.
What Investors Should Know
Mr. I. N. Vest recently inherited some money and is looking to make an investment in the shares of a company. A friend suggests that Mr. Vest consider investing in the Fun Company. Mr. Vest has completed some preliminary research and would like to examine the financial information of the Fun Company in more detail. He recently read that the company has taken on more debt, and he is worried about the implications of this situation on his potential investment.
Mr. I.N. Vest would like to know more about how he can assess the Fun Company's debt situation before deciding whether or not to invest. Let's help him out.
Companies produce a great deal of financial information, which can make analysis overwhelming. Using ratios to assess a company's financial information can help a potential investor decide whether or not they would actually like to invest in the company. Since Mr. I.N. Vest is worried about the Fun Company's debt, he would want to calculate and analyze the following ratios:
Debt to equity
Capitalization, or debt to capital
Let's go over each of these ratios in a bit more detail.
The debt ratio provides information on the percentage of assets, or things that a company owns, that have been financed by borrowing. A higher percentage indicates that a company is riskier because it is more highly leveraged. Leverage refers to using borrowed money to contribute to a company's growth and sustain operations. A highly leveraged company may be overly reliant on borrowed funds to finance its ongoing operations or expansion. The formula for calculating the debt ratio is:
Debt ratio = (total liabilities / total assets) x 100%
Let's assume that the Fun Company has total liabilities of $550,000 and total assets of $875,000. The debt ratio would be 62.8%: ($550,000 / $875,000) x 100%. This result indicates that the Fun Company is highly leveraged since it has a large amount of debt in relation to its assets, and that means it represents a riskier investment for Mr. I.N. Vest.
Debt to Equity Ratio
The debt to equity ratio compares the amount of borrowed money to the amount that shareholders have invested in the company. A higher percentage indicates that the company is more highly leveraged. Generally, creditors and borrowers like to see a large amount of shareholder investment in a company because it shows owner commitment. The formula for calculating the debt-equity ratio is:
Debt to equity ratio = (total liabilities / shareholders' equity) x 100%
Let's assume that the Fun Company has total liabilities of $550,000 and total shareholders' equity of $900,000. The debt to equity ratio would be 61.1%, or ($550,000 / $900,000) x 100%. This indicates that there is a substantial amount of owner money invested in the business. This would be an indication of lower leverage and, therefore, lower risk for Mr. I.N. Vest.
Interest Coverage Ratio
When a company borrows money, it commits to paying interest to the lender over the term of the borrowing, whether or not it has the cash flow to do so. Therefore, the interest coverage ratio is an important ratio to calculate for understanding a company's ongoing financial health because it measures how easy it is for a company to pay the interest charges on its debt. A lower ratio indicates that the company has a large amount of interest to pay in relation to its earnings and could result in cash flow problems. The formula for calculating interest coverage is:
Interest coverage ratio = earnings before interest and taxes (EBIT) / interest expense
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Let's assume Fun Company has earnings before interest and taxes (EBIT) of $675,000 and interest expenses totaling $25,000. Its interest coverage ratio would be 27: $675,000 / $25,000. This means that Fun Company could cover the interest charges it incurs on its borrowing 27 times with its current earnings. This would be a favorable result.
This capitalization (debt to capital) ratio measures the proportion of a company's total capital that is comprised of debt or borrowing. Total capital raised by a company is used to purchase items like company assets, and it contributes to a company's long-term growth. The formula for calculating the capitalization ratio is:
Capitalization (or debt to capital) ratio = (long-term debt / (long-term debt + shareholders' equity)) x 100%
Let's assume that of the Fun Company's $550,000 in total liabilities, $425,000 represents long-term debt and shareholders' equity is $900,000. The capitalization ratio would be 32.1%, or $425,000 / ($425,000 + $900,000) x 100%. This represents a low amount of leverage. The best method of assessing how favorable or unfavorable this measure is would be to compare it with ratios of competitors in the same industry.
Putting It All Together
Our analysis for the Fun Company shows mixed results. The debt to equity ratio, capitalization ratio and interest coverage ratios are all favorable, but the debt ratio shows a higher amount of leverage and could indicate a reliance on borrowed funds to finance growth and/or ongoing operations. While these ratios provide Mr. I.N. Vest with valuable information, he should also carefully examine the data that is used to calculate the ratios, as well as the situation in which the company currently finds itself. Using just the information from a single point in time could be misleading, and may not be representative of a company's ongoing performance.
A first step in assessing a company's debt is to calculate financial ratios that provide information on how leveraged a company is. Completing financial analysis by calculating the debt ratio, debt to equity ratio, interest coverage ratio and capitalization ratio provides a potential investor with the valuable information about the company's borrowing habits in relation to its shareholders' equity and how readily it can repay interest charges on borrowing. Other information, such as the company's current situation and plans for growth, should also be considered when evaluating debt.
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