Using Financial Analysis to Rate Debt

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  • 0:00 What Investors Should Know
  • 0:39 Financial Ratios
  • 5:22 Putting it All Together
  • 6:01 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

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.

Financial Ratios

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
  • Debt to equity
  • Interest coverage
  • Capitalization, or debt to capital

Let's go over each of these ratios in a bit more detail.

Debt Ratio

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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