Debt management ratios are a key indicator of a company's financial stability and are used to assess the risk of any investment that requires a loan. These ratios measure the proportion of debt to assets, equity, and other liabilities, and can be used to determine the company's ability to pay its debts. Common debt ratios include debt-equity, debt-assets, long-term debt-assets, leverage and leverage ratios. The debt ratio is calculated by dividing total debt by total assets.
A high proportion implies that assets are financed primarily with debt, rather than equity, and is considered a risky approach to financing. The lower the company's dependence on debt for asset formation, the less risky the company will be. On the other hand, the higher ratio means that a company has a high risk of insolvency, since excessive debt can lead to a heavy debt repayment burden. Financial leverage ratios usually compare a company's debts to its assets.
Common examples of financial leverage ratios include debt ratio, interest coverage ratio, capitalization ratio, debt-to-equity ratio, and fixed asset-to-equity ratio. Since this ratio is calculated annually, a decrease in the ratio would indicate that the company is performing well and is less dependent on debt for its business needs. The debt-to-equity ratio is closely related and more common than the debt ratio; instead it uses total liabilities as a numerator. This means that 46.72% of the company's capital structure is debt and the rest is provided by investors' capital.
The gross debt ratio is defined as the ratio of monthly housing costs (including mortgage payments, homeowners insurance, and property costs) to monthly income, while the total debt service ratio is the ratio of monthly housing costs plus other debts (such as car payments and credit card loans) to monthly income. The interest earned over time ratio would be high if the company's debt ratios are low, since it would be easier to cover the company's interest expenses. The debt service coverage rate is calculated by dividing the total net annual operating income by the total annual debt payments. This reflects a certain ambiguity between the terms debt and liability that depends on the circumstance. Capital-intensive companies such as utilities and pipelines tend to have much higher debt ratios than others such as the technology sector. Understanding these common debt management ratios can help accountants, analysts, investors, lenders, and finance managers understand how their companies use leverage.
