One of the most important steps in evaluating any given firm, for both investors and lenders, is to analyze debt obligations. Debt is neither fundamentally harmful nor beneficial, and many businesses borrow through standard loans or by issuing bonds. In fact, since the interest payments on debt can be tax-deductible, these often present a more cost-efficient way to expand debt through equity. Incurring debt, becoming more leveraged, becomes problematic when it is done too frequently or in too large a scale.
Fortunately, you can use the information released through a company's financial statements to help sort out businesses that borrow responsibly from those that do not. Debt is a liability, so the company's debt is going to be listed on the balance sheet. However, just looking at aggregate debt numbers does not tell you very much about the firm's financial health. Traders and lenders instead use leverage ratios to compare different debt levels.
The most well-known and widely used leverage ratio is the debt-to-equity (DE) ratio. There are different versions of DE, so you need to understand which you are looking for and why. The debt ratio, which divides total liabilities by stockholder equity, is very useful for bondholders because it offers a rough estimate of how much value is left if a company is liquidated.
You might instead see a DE ratio that divides long-term debt by stockholder equity. By ignoring short-term liabilities, this version is more focused on borrowing that was done to produce future profits. A third debt-equity formula divides the sum of long-term debt plus preferred stock by common stock. You use this if you are concerned about the amount of interest or dividend-paying liabilities relative to the firm's equity.
Interest Coverage Ratio
Another leverage ratio concerned with interest payments is the interest coverage ratio. One problem with only reviewing the total debt liabilities for a company is they do not tell you anything about the company's ability to service the debt. This is exactly what the interest coverage ratio aims to fix. This ratio, which equals operating income divided by interest expenses, showcases the company's ability to make interest payments. You generally want to see a ratio of 3.0 or higher, although this varies from industry to industry.
Times interest earned (TIE), also known as a fixed-charge coverage ratio, is a variation of the interest coverage ratio. This leverage ratio attempts to highlight cash flow relative to interest owed on long-term liabilities. To calculate, find the company's earnings before interest and taxes (EBIT), then divide by the interest expense of long-term debts. Use pre-tax earnings because interest is tax-deductible; the full amount of earnings can eventually be used to pay interest. Again, higher numbers are more favorable.
Some industries are naturally more debt-intensive than others, so you are best off comparing leverage ratios between "like" competitors in the same sector. Also, look at ratios over a period of time, not just for one given period, and look for trends. For example, operating income that grows more slowly than interest expenses is not a good sign.