Business Debt Levels and Ratio Analysis
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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 debt levels 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 a company’s creditworthiness, also use these metrics.
Some commonly used ratios are:
Debt Service Coverage Ratio (DSCR)
This ratio 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 annually and your interest and principal payments are $50,000, your DSCR is 2.0. A DSCR of less than one means that a firm cannot meet its current debt service obligations from operating profits and is headed toward default.
DSCR Calculator
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Interest Coverage Ratio (ICR)
The Interest Coverage Ratio is similar to the DSCR above and measures a firm’s ability to 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.”
Interest Coverage Ratio (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 instead of 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 that this ratio increases, it can indicate that profits cannot support ongoing operations and shortfalls are offset by additional debt.
These ratios are helpful when assessing a company’s ability to service its debt now and in the future. Many ratio calculations 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.
D/E Ratio Calculator
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