Debt ratio measure the actual extent to which a lending broker uses debt to fund its operations, as well as the ability of the entity to afford that debt. These ratios are very important to investors, whose equity investments in a business could go at risk when the debt level is too much.
Lenders are also avid users of these ratios, to determine the extent to which loaned funds could be at risk. The key debt ratios are as follows:
- Debt to equity ratio. Calculated by dividing the total amount of debt by the total amount of equity. The intent is to see if funding is coming from a reasonable proportion of debt. Lenders like to see a large equity stake in a business.
- Debt ratio. Calculated by dividing total debt by total assets. A high ratio implies that assets are being financed primarily with debt, rather than equity, and is considered to be a risky approach to financing.
- Debt service coverage ratio. Calculated by dividing total net annual operating income by the total of annual loan payments. This measures the ability of a business to pay back both the principal and interest portions of its debt.
- Interest coverage ratio. Calculated by dividing earnings before interest and taxes by interest expense. The intent is to see if a business can at least pay for its interest payments when due, even if the balance of a loan cannot be repaid. This measure works well in cases where a loan is expected to be rolled over into a new loan when it reaches maturity.
It is employed to plot these measurements over a trend line. This reveals the lifestyle of any issues in which the debt load of entity is increasing over time, or where its ability to repay debt is declining. Debt ratioare a particular concern every time a business wants some sort of rating agency to offer a rating one of its debt securities; if the ratios reveal a higher debt load, a rating bureau may assign a minimal rating that increases the interest cost with the securities to always be sold.