Last updated on Mar 19, 2024
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Debt-to-Equity Ratio
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Debt-to-EBITDA Ratio
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Interest Coverage Ratio
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Cash Flow-to-Debt Ratio
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Here’s what else to consider
Debt is a common and often necessary source of financing for businesses, but too much of it can pose serious risks. Excessive debt can limit a company's flexibility, increase its interest expenses, and reduce its profitability and cash flow. It can also make a company more vulnerable to economic downturns, competitive pressures, and credit rating downgrades. How can you determine if a company has too much debt? Here are some useful tools and ratios to help you assess a company's debt situation.
Key takeaways from this article
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Debt-to-EBITDA ratio:
This metric offers insights into how many years it would take a company to pay off its debt using its earnings before interest, taxes, depreciation, and amortization. It's especially helpful in comparing companies within the same industry.
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Interest coverage ratio:
This ratio reveals how comfortably a company can pay its interest expenses from its earnings. A higher number suggests stronger solvency and profitability, serving as a quick health check on a company’s financial stress levels.
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1 Debt-to-Equity Ratio
The debt-to-equity ratio measures how much debt a company has relative to its shareholders' equity. It indicates how much leverage a company is using to finance its assets and operations. A high debt-to-equity ratio means that a company has more debt than equity, which implies a higher risk of default and insolvency. A low debt-to-equity ratio means that a company has more equity than debt, which implies a lower risk and a stronger financial position. The optimal debt-to-equity ratio depends on the industry, the business cycle, and the company's growth strategy, but generally, a ratio below 1 is considered preferable.
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- Hiten Keshave CA(SA) MBA Founder @ Unconventional CA | Specializing in Entrepreneur Development | Author
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Definitely this is one of the easiest mechanisms to identify if an entity is overgeared or not. Alternatively assessing cashflow and interests are good indicators as well
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1. Calculate the company's debt-to-equity ratio by dividing its total debt by its total equity.2. Calculate the debt-to-asset ratio by dividing the total debt by the total assets. 3. Evaluate interest coverage ratio by dividing the company's earnings before interest and taxes (EBIT) by its interest expense. 4. Assess debt service coverage ratio by dividing the company's net operating income by its total debt service obligations.5. Compare company's debt ratios to industry benchmarks or peers within the same sector.6. Evaluate the company's cash flow to assess its ability to generate sufficient cash.7. Review the company's credit rating and debt covenants.8. Consider the company's growth prospects and investment opportunities.
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A high ratio means outside borrowings are used which requires generating significant cash flow to repay principal borrowed and interest expense.On the other hand, a low ratio means business is financed by shareholder's equity. Let's say you're analyzing a major retail chain. Their debt-to-equity ratio is 1.5. This explains that for every $1.50 of debt they have, there's $1.00 invested by shareholders. This suggests a moderate level of leverage. The company is using debt-to-finance business operations, but it's not overly reliant on borrowed funds.There is no ideal debt-to-equity ratio that applies universally; however, it can be compared with industry and benchmarked.
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1-Debt Ratios: Analyze Debt-to-Equity (D/E) and Debt-to-Asset ratios. Higher ratios suggest more debt financing, potentially risky. Industry benchmarks are crucial for comparison.2- Interest Coverage: This ratio shows if a company earns enough to cover interest payments. A lower ratio indicates potential debt servicing issues.3- Cash Flow: Look at cash flow generation. Can the company comfortably cover debt obligations with its current income?Debt tolerance varies by industry and growth stage. Startups may have higher debt for initial growth, while established firms might have lower ratios. Consider interest rates too - lower rates make debt more manageable.
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Razão Dívida/Equity (Dívida/Patrimônio Líquido): Essa métrica compara o total da dívida da empresa com o seu patrimônio líquido. Quanto maior a razão, mais endividada a empresa está. Mais o grau de endividamento, deve ser analisado de forma estrategia.
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2 Debt-to-EBITDA Ratio
The debt-to-EBITDA ratio measures how many years it would take a company to pay off its debt using its earnings before interest, taxes, depreciation, and amortization (EBITDA). It indicates how easily a company can service its debt obligations from its operating cash flow. A high debt-to-EBITDA ratio means that a company has a large amount of debt relative to its cash flow, which implies a lower ability to cover its interest and principal payments. A low debt-to-EBITDA ratio means that a company has a small amount of debt relative to its cash flow, which implies a higher ability to pay off its debt quickly. The acceptable debt-to-EBITDA ratio varies by industry and market conditions, but generally, a ratio below 3 is considered healthy.
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This metric provides insights into a company's ability to repay its debt using its operating cash flow before excluding interest, tax, depreciation, and amortization.It provides information that in case the EBITDA is directed towards debt repayment, then how many years it takes to knock-off the borrowings. There is no ideal ratio but one should considered factors like capital-intensive industries might naturally have a higher debt-to-EBITDA ratio compared to service-oriented industries.
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Debt Service Coverage Ratio(DSCR) Also needs to check the company's ability to repay debt.DSCR- EBITDA/ Interest+ PrincipalMinimum 1 DSCRDSCR -1.33 Tight1.5 Moderate1.7 Adequate as per bank (It may vary bank to bank)
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Free Cash FlowFree cash flow (FCF)is the cash a companygenerates after taking into consideration cash outflows that support its operations and maintain its capital assets. In other words, free cash flow is the cash left over after a companypays foritsoperating expensesandcapital expenditures(CapEx).Investors use free cash flowto measure whether a company might have enough cash for dividends or share buybacks. In addition, the more free cash flow a company has, the better it is placed to pay down debt and pursue opportunities that can enhance its business, making it an attractive choice for investors.Free Cash Flow= Operating Cash Flow - Capital Expenditures
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3 Interest Coverage Ratio
The interest coverage ratio measures how many times a company can pay its interest expenses with its operating income. It indicates how comfortably a company can meet its interest obligations from its earnings. A high interest coverage ratio means that a company has enough income to pay its interest expenses several times over, which implies a strong solvency and profitability. A low interest coverage ratio means that a company has barely enough income to pay its interest expenses, which implies a weak solvency and profitability. A negative interest coverage ratio means that a company has more interest expenses than income, which implies a severe liquidity and solvency problem. The minimum interest coverage ratio depends on the industry and the lender's requirements, but generally, a ratio above 2 is considered adequate.
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Borrowings comes with interest obligations. This metric explains about how many times a business can cover its interest obligations with its earnings before taxes and other expenses.Interest Coverage Ratio = Operating Income / Interest ExpenseLet's analyze a manufacturing company. Their interest coverage ratio is 5. This means they can cover their interest expenses five times over with their operating income. This is a strong ratio, indicating the company has a significant buffer and can comfortably manage its debt obligations.
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To calculate the interest coverage ratio, follow these steps:- Determine the company's earnings before interest and taxes (EBIT). This can usually be found on the company's income statement.- EBIT = Operating Income + Non-operating Income- Identify the company's interest expenses for the same period. Interest expenses can be found on the income statement or in the notes to the financial statements.- Use the following formula to calculate the interest coverage ratio:Interest Coverage Ratio = EBIT / Interest ExpensesThe interest coverage ratio helps determine if a company has too much debt by providing insight into its ability to service its debt obligations.
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4 Cash Flow-to-Debt Ratio
The cash flow-to-debt ratio measures how much of a company's debt can be paid off with its annual cash flow. It indicates how quickly a company can reduce its debt burden from its cash generation. A high cash flow-to-debt ratio means that a company has enough cash flow to pay off a large portion of its debt within a year, which implies a low leverage and a high liquidity. A low cash flow-to-debt ratio means that a company has insufficient cash flow to pay off a significant part of its debt within a year, which implies a high leverage and a low liquidity. The ideal cash flow-to-debt ratio depends on the industry and the debt maturity, but generally, a ratio above 0.25 is considered satisfactory.
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It evaluates the relationship between the cash flow and its borrowings, shedding light on the company's liquidity and leverage.Cash Flow-to-Debt Ratio= Total Debt /Annual Cash Flow. Example: Annual Cash Flow: 1,500,000Total Debt: 3,500,000Cash Flow-to-Debt Ratio=1,500,000/3,500,000=0.43The cash flow-to-debt ratio indicates that it can cover 43% of its total debt within a year based on its annual cash flow.
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5 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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- Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT. Tax | Financial Reporting | Deloitte | CV Optimization
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The best way to dertmine if a company's debt is escessive is to check the interest cover ratio. The moment a company is paying too much of its revenue on debt servicing, then the debt is too high. Just like Nigeria is currently experiencing where over 80% of its revenue goes to debt servicing.
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The various ratio determined should be compared it with industry trends to get more understanding on ideal ratio. Also, one should also review the cash flows from financing activities in the cash flow statement. Understand the accounting policies on borrowing cost, implication of major lease agreement signed which is an obligation affecting the cash flow impacting the profitability.
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