Business Debt Levels and Ratio Analysis
How can a company determine whether it has too much debt?
There are widely used financial measures that can be used to evaluate debt levels, both absolutely and relative to other firms in a given industry. These indicators are often ratios that compare levels of debt versus equity or measure a firm’s ability to service its debt by comparing profits or cash flow with interest charges. Banks and other lenders in evaluating the creditworthiness of a company also use these metrics.
Some commonly used ratios are:
Debt Service Coverage Ratio (DSCR)
This ratio basically indicates whether or not a firm generates enough income to pay the interest and principal on its debt without seeking additional funding. A DSCR should be well over 1.0. For example, if your company generates $100,000 in profit a year and your interest and principal payments are $50,000, then your DSCR is 2.0. A DSCR less than one means that a firm cannot meet its current debt service obligations from operating profits and is headed toward default.
Here is a tool to calculate your company’s DSCR
DSCR Calculator
Interest Coverage Ratio (ICR)
Interest Coverage Ratio is similar to the DSCR above and measures a firm’s ability to just cover its interest charges through operating profits. It is simply Net income divided by total interest charges for the same period. Also called “Times Interest Earned.”
Calculate your company’s ICR below:
ICR Calculator
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Debt to Equity Ratio (D/E)
This ratio shows the proportion of a company’s assets funded by debt as opposed to owners’ equity. This is a measure of a company’s financial leverage and long-term solvency. The higher this ratio is, the riskier it becomes for lenders and prospective investors. If a trend shows this ratio increases, it can indicate that profits cannot support ongoing operations and shortfalls are being offset with additional debt.
These ratios are useful when assessing a company’s ability to service its debt both now and in the future. There are many ratio calculations that are used to evaluate company debt and risk – these are a few that are widely used. Many financial ratios have standards that vary by industry. It is wise to research what values are typical of other firms in your industry and track your ratios over time. This will often point out developing trends that may need attention.
Calculate your business’ D/E:
D/E Ratio Calculator
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Author: Marc J Marin
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