Debt Ratios Look at Financial Viability/Leverage
The Ratio of Debt to Equity Has Implications for Return on Equity
Apr 20, 2009
Debt funds typically mean funds borrowed on which the borrower has to pay interest. Debt funds and owner's funds together constitute the capital available to a firm for deployment in business. The profit that remains after payment of interest (and taxes) is the amount available for distribution to the business owners.
Significance of Debt Ratios
Debt ratios check the financial structure of the business by comparing debt against total capital, against total assets and against owners' funds. A related ratio, interest coverage ratio, looks at the adequacy of profits to meet interest obligations. The ratios help check how "leveraged" a company is, and also the financial maneuverability of the company in difficult times. The concepts of leverage and other issues are examined below.
Implications of Debt Funding
A company is said to be highly leveraged if it uses a high proportion of debt to fund its assets. The concept of leverage is explained below:
A business needs $100,000 to set up facilities and start operations. It earns $10,000 net profit in a year.
- If the entire $100,000 is raised from owners, they get a 10% return on their investment.
- If $50,000 is raised as term loan at 5% interest, and $50,000 from owners
- $2,500 is paid out as interest on the loan from $10,000 leaving $7,500 for owners.
- $7,500 works out as a return of 15% on the owner funds of $50,000
Leveraging through debt can thus provide higher returns to shareholders, provided the business is able to earn on the total funds a rate higher than the interest rate.
The downside of high leverage is illustrated next:
- The profit of the above company falls to $3,000, which works out to a 3% return if the entire capital was raised from owners.
- If $50,000 was raised as debt, $2,500 will have to be paid as interest, leaving only $500 for owners, i.e. a 1% return on owner funds of $50,000.
If profit falls further, the company might find itself unable even to pay the interest, which can threaten the very survival of the company.
The Debt Ratios
Debt Ratio = Total Liabilities / Total Assets (Total liabilities include even non-interest-bearing operational liabilities)
Debt to Equity Ratio (Debt Capital Ratio) = Total Liabilities / Shareholders' Equity.
Capitalization (Term Debt Ratio) = Long-term Debt / (Long-Term Debt + Shareholders' Equity).
Interest Coverage Ratio = Profit before Interest and Taxes (PBIT) / Interest Expense
Interest is a tax-deductible expense. If the interest expense was not there, tax burden would have been higher. Hence the earnings before taxes is considered for computing the coverage.
Debt ratios and the related interest coverage ratio checks the soundness of a company's financing policies. One the one hand, use of debt funds can enhance returns to owners. On the other hand, high debt can mean that the company will find it difficult to raise funds during lean periods of business. High debt can also mean high interest payouts that the company might find unable to service during lean periods.
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