Financial ratios can be used to assess a company's capital structure and current risk levels, often in terms of a company's debt level and risk of default or bankruptcy. These ratios are used by investors when they are considering investing in a company. Whether a firm can manage its outstanding debt is critical to the company's financial soundness and operating ability. Debt levels and debt management also significantly impact a company's profitability, since funds required to service debt reduce the net profit margin and cannot be invested in growth.
Some of the financial ratios commonly used by investors and analysts to assess a company's financial risk level and overall financial health include the debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the degree of combined leverage (DCL).
- Risk ratios consider a company's financial health and are used to help guide investment decisions.
- If a company uses revenues to repay debt, those funds cannot be invested elsewhere within the company to promote growth, making it a higher risk.
- The most common ratios used by investors to measure a company's level of risk are the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio.
The debt-to-capital ratio is a measure of leverage that provides a basic picture of a company's financial structure in terms of how it is capitalizing its operations. The debt-to-capital ratio is an indicator of a firm's financial soundness. This ratio is simply a comparison of a company's total short-term debt and long-term debt obligations with its total capital provided by both shareholders' equity and debt financing.
Debt/Capital = Debt / (Debt + Shareholders' Equity)
Lower debt-to-capital ratios are preferred as they indicate a higher proportion of equity financing to debt financing.
The debt-to-equity ratio (D/E) is a key financial ratio that provides a more direct comparison of debt financing to equity financing. This ratio is also an indicator of a company's ability to meet outstanding debt obligations.
Debt/Equity = Debt / Shareholders' Equity
Again, a lower ratio value is preferred as this indicates the company is financing operations through its own resources rather than taking on debt. Companies with stronger equity positions are typically better equipped to weather temporary downturns in revenue or unexpected needs for additional capital investment. Higher D/E ratios may negatively impact a company's ability to secure additional financing when needed.
A higher debt-to-equity (D/E) ratio may make it harder for a company to obtain financing in the future.
Interest Coverage Ratio
The interest coverage ratio is a basic measure of a company's ability to handle its short-term financing costs. The ratio value reveals the number of times that a company can make the required annual interest payments on its outstanding debt with its current earnings before interest and taxes (EBIT). A relatively lower coverage ratio indicates a greater debt service burden on the company and a correspondingly higher risk of default or financial insolvency.
Interest Coverage = EBIT / Interest Expense
A lower ratio value means a lesser amount of earnings available to make financing payments, and it also means the company is less able to handle any increase in interest rates. Generally, an interest coverage ratio of 1.5 or lower is considered indicative of potential financial problems related to debt service. However, an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.
Investors consider that a company with an interest coverage ratio of 1.5 or lower is likely to face potential financial problems related to debt service.
Degree of Combined Leverage
The degree of combined leverage (DCL) provides a more complete assessment of a company's total risk by factoring in both operating leverage and financial leverage. This leverage ratio estimates the combined effect of both business risk and financial risk on the company's earnings per share (EPS), given a particular increase or decrease in sales. Calculating this ratio can help management identify the best possible levels and combination of financial and operational leverage for the firm.
DCL = % Change EPS / % Change Sales
A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage because high leverage means more fixed costs to the firm.
The Bottom Line
Financial ratios are used in fundamental analysis to help valuate companies and estimate their share prices. Certain financial ratios can also be used to evaluate a firm's level of risk, especially as it relates to servicing debts and other obligations over the short and long run.
This analysis is used by bankers to grant additional loans, and by private equity investors to decide investments in companies and use leverage to pay back debt on their investments or augment their return on investments.