Debt ratios

Debt ratios measure the extent to which an organization uses debt to fund its operations, as well as the ability of the entity to pay for that debt. These ratios are important to investors, whose equity investments in a business could be put at risk if the debt level is too high. Lenders are also avid users of these ratios, to determine the extent to which loaned funds could be at risk. The key debt ratios are as follows:

  • Debt to equity ratio. Calculated by dividing the total amount of debt by the total amount of equity. The intent is to see if funding is coming from a reasonable proportion of debt. Lenders like to see a large equity stake in a business.
  • Debt ratio. Calculated by dividing total debt by total assets. A high ratio implies that assets are being financed primarily with debt, rather than equity, and is considered to be a risky approach to financing.
  • Debt service coverage ratio. Calculated by dividing total net annual operating income by the total of annual loan payments. This measures the ability of a business to pay back both the principal and interest portions of its debt.
  • Interest coverage ratio. Calculated by dividing earnings before interest and taxes by interest expense. The intent is to see if a business can at least pay for its interest payments when due, even if the balance of a loan cannot be repaid. This measure works well in cases where a loan is expected to be rolled over into a new loan when it reaches maturity.

It is useful to plot these measurements on a trend line. Doing so reveals the existence of any issues where the debt load of an entity is increasing over time, or where its ability to repay debt is declining. Debt ratios are a particular concern when a business wants a rating agency to give a rating to one of its debt securities; if the ratios reveal a high debt load, a rating agency may assign a low rating that increases the interest cost of the securities to be sold.