Table of Contents |
Debt management ratios measure a firm’s ability to repay its long-term debt. These two ratios will be discussed today:
The higher this ratio, the greater the risk of the firm’s operations. Additionally, a high debt ratio may indicate the low borrowing capacity of a firm. This, in turn, will lower the firm’s financial flexibility. Like all the other ratios, a debt ratio should be compared with the industry average or with the competition.
The total assets are $38,834. The total liabilities are $21,734 for the current liabilities and $5,600 for the long-term liabilities, for a total of $27,334. If we divide the total liabilities by the total assets, we get 0.70. This means that 70% of ABC’s assets are financed by debt rather than by equity. Upon comparison, we may find that this is high and may limit ABC’s financial flexibility and borrowing power.
The second debt management ratio is the times interest earned ratio. The times interest earned, or TIE, measures the company’s ability to honor its debt payments. This is also sometimes called interest coverage.
It is calculated by dividing the EBIT (earnings before interest and taxes) by the interest charges.
It is a great tool for measuring a company’s ability to meet its debt obligations. Typically, it’s a warning sign when the interest coverage falls below 2.5. When the times interest earned ratio is less than 1, the company is not generating enough cash from its operations to meet its interest obligations. The company would have to either use the cash on hand to make up the difference or borrow funds.
In this simple example, we are looking for the EBIT. That number here is the operating income of $9,060,000, and the interest expense is $1,610,000. If we divide $9,060,000 by $1,610,000, we get 5.62. So, in this example, this company is in fairly good shape in terms of interest coverage.
Source: THIS TUTORIAL HAS BEEN ADAPTED FROM "BOUNDLESS FINANCE" PROVIDED BY LUMEN LEARNING BOUNDLESS COURSES. ACCESS FOR FREE AT LUMEN LEARNING BOUNDLESS COURSES. LICENSED UNDER CREATIVE COMMONS ATTRIBUTION-SHAREALIKE 4.0 INTERNATIONAL.
