Which of the following ratios is used to measure the ability of the firm to repay its debt?
Financial ratios are used to provide a quick assessment of potential financial difficulties and dangers. Ratios provide you with a unique perspective and insight into the business. If a financial ratio identifies a potential problem, further investigation is needed to determine if a problem exists and how to correct it. Although there are often specific benchmarks attached to ratios to indicate when there is cause for concern, ratios should also be thought of as a continuum from weak to strong with the stronger the ratio the better. Ratios can identify problems by the size of the ratio but also by the direction of the ratio over time. Show
Liquidity RatiosCurrent Ratio - A firm’s total current assets are divided by its total current liabilities. It shows the ability of a firm to meets its current liabilities with current assets. Quick Ratio - A firm’s cash or near cash current assets divided by its total current liabilities. It shows the ability of a firm to quickly meet its current liabilities. Net Working Capital Ratio - A firm’s current assets less its current liabilities divided by its total assets. It shows the amount of additional funds available for financing operations in relationship to the size of the business. Asset Management RatiosDays Sales Outstanding - A firm’s accounts receivables divided by its average daily sales. It shows the average length of time a firm must wait after making a sale before it receives payment. Fixed Asset Turnover Ratio - A firm’s total sales divided by its net fixed assets. It is a measure of how efficiently a firm uses its plant and equipment. Inventory Turnover Ratio - A firm’s total sales divided by its inventories. It shows the number of times a firm’s inventories are sold-out and need to be restocked during the year. Total Assets Turnover Ratio - A firm’s total sales divided by its total assets. It is a measure of how efficiently a firm uses its assets. Debt Management RatiosDebt to Asset Ratio - A firm’s total debt divided by its total assets. It is a measure of how much of the firm is debt financed. Debt Coverage Ratio or Debt Service Coverage Ratio (DSCR) - A firm’s cash available for debt service divided by the cash needed for debt service. It is a measure of a firm’s ability to service its debt obligations. Times Interest Earned Ratio (TIE) - A firm’s earnings before interest and taxes (EBIT) divided by its interest charges. It shows a firm’s ability to meet its interest payments. It is also called the interest coverage ratio. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Coverage Ratio - A firm’s cash flow available to meet fixed financial charges divided by the firm’s fixed financial charges. It shows the ability of a firm to meet its fixed financial charges. Profitability RatiosProfit Margin on Sales - A firm’s net income divided by its sales. It shows the ability of sales to generate net income. Basic Earning Power (BEP) - A firm’s earnings before interest and taxes (EBIT) divided by its total assets. It shows the earning ability of a firm’s assets before the influence of taxes and interest (leverage). Return on Total Assets (ROA) - A firm’s net income divided by its total assets (both debt and equity supported assets). It shows the ability of the firm’s assets to generate net income. Interest expense is added back to net income because interest is a form of return on debt-financed assets. Return on Equity (ROE) - A firm’s net income divided by its equity. It shows the ability of the firm’s equity to generate profits. Return on Investment (ROI) - A firm’s net income divided by the owner’s original investment in the firm. Earnings per Share - A firm’s net income per share of stock. Market Value RatiosPrice/Earnings Ratio (P/E) - The price per share of a firm is divided by its earnings per share. It shows the price investors are willing to pay per dollar of the firm’s earnings. Price/Cash Flow Ratio - The price per share of a firm divided by its cash flow per share. It shows the price investors are willing to pay per dollar of net cash flow of the firm. Market-to-book value (M/B) - The market value of a firm is divided by its book value. Don Hofstrand, retired extension value added agriculture specialist, One of the most crucial parameters to assess the health of a particular company is its financial position. The debt ratio, also known as the risk gearing ratio, is used to carry out the financial leverage of a company and to calculate the weight of the debt ratio and total debt and financial liabilities to total capital (equity held by the shareholder). Let's have a look at what's in store:
IntroductionIn simple words, the debt ratio is calculated to measure the company’s capability to pay back its liabilities and obligations. If the debt ratio is higher, the company is receiving more money through risky loans, and if the potential debt is too high, it is at risk of bankruptcy during these periods. It is a substantial consideration for investors and lenders, as they prefer a low debt ratio as they feel that their interests are protected when the business is not performing well. However, this debt ratio is beneficial in determining the amount of leverage the company is using, as it is a comparison of the company's total liabilities to its capital and determine. The risk of long-term debt is different from short-term debt, so investors are changing their gear to focus entirely on long-term debt. What Is the Debt Ratio?One must always spend according to what he has and borrow according to what he can repay. It is a basic life rule which should be thoroughly applied in businesses and organizations. The debt ratio is a simple financial indicator that represents a debt to capital. The Technical Side of Debt RatioThe formula for the debt ratio is dividing the total debt of the company by the total assets/stocks/equity held by the company/shareholders. Debt ratio = Total Liabilities / Total Asset or Shareholder’s Equity
Net Assets= Assets – Liabilities
As a shareholder, you become a part-owner of the company and your ownership depends on the percentage of shares you own in proportion to the total number of shares that a company has issued. More preference is given to the company`s creditors, lenders, and debenture holders than the equity shareholders at the time of disbursement. Investing in stocks is a simple calculation wherein stockholders are paid off before the owners are paid back from the company`s assets. SE is the capital's ability to cover a company's liabilities. It can be negative or positive depending on the business activities of the company. This is an important indicator of a company's financial condition and makes the debt ratio an important representation of a company's financial condition. Interpretation of Debt RatioThis debt ratio is useful for analyzing a company's financing strategy. This indicator helps you know whether a company is using stocks or liabilities to do business.
Interpretation: As we correctly stated, high-level leverage means that the company is in the red and borrows more than its own money, and low-level leverage means that the company uses more of its assets. And it shows that there is little borrowing. Now, by definition, we can conclude that high leverage is bad for businesses and is negatively evaluated by analysts. Analysis of InterpretationLooking at the debt ratio again, the debt ratio is calculated by dividing the total debt by capital. Depending on the type of industry, a high-level DE may be common in some, while a low-level debt ratio may be common in others. Capital-intensive industries such as manufacturing can have a high debt ratio, while services and technology-focused industries have relatively low capital and growth needs, which can lead to a low debt ratio. This shows that a company's debt ratio needs to be treated with caution compared to other industries. What is Total Debt?A company's total debt is the sum of current debt, long-term debt, and other fixed payment obligations that the company incurs during its normal operating cycle. Creating a debt plan helps you classify your debt according to specific parts. Not all short-term and long-term debt is considered debt. Let us understand what represent debt and what doesn’t: Considered debt:
Not considered debt:
How is the Debt Ratio Calculated?The debt ratio is formulated by dividing a company’s total liabilities by the total assets/shareholder’s equity. The formula is like this: Debt ratio = Total Liabilities/Total Assets or Shareholder’s Equity The total liabilities include short-term and long-term debts, along with fixed payments obligations. Calculating a company's debt ratio is imperative to analyze if a company is exposed to financial risk. The general method of calculating debt ratio: Determine the total debtYour company's total debt is the sum of that debt and other financial obligations. It is a combination of short-term debt and long-term debt. Examples of total debt are wages, credit card debt, utilities, or invoices to be paid. Most often, it's the money your company is borrowing at any given time. Determine your total assets in the business sense"Total assets" refers to the total number of assets in a company. Assets retain their value, but can also be depreciated over time. Examples of total assets include commodities, inventories, and accounts receivable. They are units owned by your company. Calculate the debt ratioOnce you have identified both your total liabilities and your total assets, you are ready to calculate your debt ratio. To calculate the debt ratio, divide the total liabilities by the total assets. It is important to note that the low or high debt ratio depends on the particular industry. However, a debt ratio greater than 1 indicates high future financial risk, and a low debt ratio (usually around 0.5) means that the business has a good financial base and can be protracted. Examples of debt ratio for personal and business purposesExample 1Mr. Rajesh has a bakery with total assets of 50,000$ and liabilities of 20,000$, the debt ratio is 40%, or 0.40. This debt ratio is calculated by dividing 20,000$ (total liabilities) by 50,000$ (total assets). If the debt ratio is 0.4, the company is in good shape and may be able to repay the accumulated debt. Example 2Mr. Narayan has a furniture business and has taken a business loan of 100,000$ and retained earnings of 25,000$, its debt ratio will be 4. This is because 100,000$ (total debt) divided by 25,000$ (total capital) is 4 (debt ratio) which is a high-risk debt ratio and a dangerous investment. Example 3Let`s say Mr. Max is running a clothing store and pays its employees 50,000$ and has total assets amounting to 100,000$. To calculate the debt ratio, divide 50,000$ (liabilities) by 100,000$ (assets). This means the store has a debt ratio of 0.5 which is generally considered favorable. Example 4Let's say you recently ventured into a startup company and have borrowed funds from a bank as a personal loan. The bank has determined that your business has total assets of 50,000$ and total liabilities of 5,000$. Divide 5,000$ by 50,000$ to calculate the debt ratio. This results in a debt ratio of 0.1. This is a very cheap and low-risk debt ratio. In these situations, your bank should be fine in lending you a loan to initiate your business. Example 5You are planning to take a holiday with your family. Let's say you have 600,000$ in total assets and 150,000$ in liabilities. To calculate the debt ratio, divide the liability (150,000$ ) by the total assets (600,000$ ). This results in a debt ratio of 0.25 or 25 percent. Since this is less than 1, this is considered a low-risk debt ratio and you may go for that much longed-holiday or even seek financial assistance from a bank to pay for your vacation. Importance and use of debt ratio formulasThis debt ratio formula is used for the following purposes. 1. Top Management:The first group to use this debt ratio is the top management of the company, which is directly responsible for the development or reduction of the company. Based on this indicator, top management recognizes whether the company has sufficient resources to meet its obligations. 2. Investors:The second group that is interested in finding out the debt ratio of a company is investors, who want to confirm the position of the company before investing money in it. For this reason, investors need to know if a company has sufficient assets to cover the costs of its liabilities and other obligations. This indicator also measures the financial leverage of a company. It also tells investors the leverage of the company. If a company has a higher level of liability compared to its assets, it has higher financial leverage and vice versa. 3. To Estimate the Financial Leverage:The debt ratio is an important way to identify the financial stability and health of a business. If a company's debt ratio exceeds 0.50, the company is called a leveraged company. This shows that the company has more leverage in its capital structure. Companies with low debt ratios are said to be conservative. Companies with a debt ratio of less than 0.50 are stable and have the potential for longevity. 4. For Financing:Companies can raise additional funding from outside for expansion. Benchmark debt ratios can vary from industry to industry, but a company's .50 debt ratio can be a reasonable one to obtain extra financing for the smooth running of the company. If a company's debt ratio is 1, it means that the company's total debt is equal to its total assets. Or you could say that if a company wants to repay its debt, it has to sell all its assets. If a company has to pay its debt, it has to sell all its assets, in which case the company can no longer operate. Benefits of Calculating the Debt Ratio
Limitations of the Debt Ratio
What Are the Risks Associated with Debt Ratio?High levels of debt carry two major risks.
What is the ideal Debt Ratio?The simple answer to this is that the debt ratio quota should ideally not exceed 2. A debt ratio of 2 means that the company has 1 unit of capital for every 2 units of debt. This is very high and indicates a high risk. Ideally, there is no such thing as an ideal debt ratio. Yes, the debt ratio greater than 2 is very high, but in some industries such as manufacturing and mining, the normal debt ratio can be 2 or more. In other industries, debt ratio 2 may not be normal. What we need to see is the industry average. From this, we can infer you should be vigilant while comparing debt ratios and that the same should be done for companies in the same industry and industry benchmarks. Types of Debt Ratio
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Related ArticlesFinancial Ratios - All you Need to Know After striving for months to generate revenue as a company, how do you ascertainyour financial performance? Or when you want to invest in a company, how do youknow whether it is a profitable buy or not? Most importantly, how do you analyzewhere your firm stands financially in the competitive mark… Deskera BlogRhema HansWhat are Accounting Ratios? Accounting: the one word a majority of the people seem to be scared of. Numbercrunching isn’t everyone’s cup of tea, right? However, once you understand thepurpose of it, accounting starts to make more sense than anything else. It makes total sense too. Every business setup needs to operate with… Deskera BlogDeskera Content TeamWhat is Liquidity Ratio? Guide with Examples Liquidity ratios are fundamental in forecasting the future cash flows of thefirm. They are widely used for this purpose and for deciding about financingmix, capital structure, investment, etc. These liquidity ratios are used to measure a company’s ability to pay itsshort-term obligations. Liquid… Deskera BlogDeskera Content TeamWhat is Profitability Ratio? Types, Examples, and Why they Matter? Are profits always on your mind?Want to track the KPIs that matter?What can you add to your already existing KPI List to measure the success ofyour business? You are about to learn 8 Profitability Ratios that will help boost yourbusiness. In this post, we aim to highlight the significance of t… Deskera BlogDeskera Content TeamWhat Is Operating Cash Flow Ratio? Guide with Examples Are you looking for a way to measure your company’s cash flow, debt, orliquidity ratio? Are impending product launches, major expenses, or expansion plans not lettingyou sleep at night? Then you must get an idea of the company’s operating cash flow ratio to have aclear picture of its earnings.… Deskera BlogDeskera Content TeamWhich ratio is used to monitor a firm's ability to repay debt?2. Solvency Ratios. Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt.
Which ratio shows ability of a firm to repay its interest?The times interest earned ratio is an indicator of the company's ability to pay interest as it comes due. It is calculated by dividing earnings before interest and taxes (EBIT) by interest expense. A times interest earned ratio of 2–3 or more indicates that interest expense should reasonably be covered.
What ratio helps determine the ability of a firm to repay its shortThe current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.
What types of ratios measure the ability of a business to pay its debts when due?Liquidity ratios
These measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts, and provide a broad overview of your financial health. The current ratio measures your company's ability to generate cash to meet your short-term financial commitments.
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