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Firms within the capital-intensive oil and gas industry must always keep a close eye on their debt. While debt isn’t always bad, and can even increase shareholder returns, high levels strain a company’s credit ratings and weaken its ability to finance other projects.

Analysts use specific leverage ratios to compare firms within the industry. A basic understanding of these ratios helps to better evaluate oil and gas stocks.

The debt-to-EBITDA ratio measures a company’s ability to pay off its incurred debt. Oil and gas companies typically carry many years of debt, and this ratio shows how many years of EBITDA is needed to pay it off. A number higher than three often means trouble.

The interest coverage ratio reveals how easily a company can pay interest on its outstanding debt. It’s a company’s EBIT, divided by its interest expense over the same period. If the multiple is higher than one, a company should have enough capital to pay its interest expenses. Ideally, oil and gas firms should aim for a factor of 3-to-1.

The debt-to-capital ratio shows how a company is financing its operations. It’s calculated as debt -- including all long- and short-term obligations -- divided by capital, which is shareholders’ equity plus debt. The higher the ratio, the more the company uses debt to finance its operations, and the greater the risk of default.

Finally, the debt-to-equity ratio, one of the most common financial leverage ratios, reveals the portions of debt and equity a company uses to finance its assets. It’s the company’s total liabilities divided by shareholders’ equity. A high ratio means the company has been aggressive in financing its growth with debt. The added interest expenses can result in volatile earnings.

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