The financial ratios of indebtedness or leverage analyze the firm's capital structure, measuring its financing with debt capital and determining its ability to meet its obligations.
Gitman and Zutter (p.71) indicate that within this category of ratios there are two types, the measures of the degree of indebtedness and the measures of the ability to pay debts:
1. The degree of indebtedness
It measures the amount of debt relative to other significant figures on the balance sheet. A couple of common measures of the degree of indebtedness are the debt ratio and the debt-capital ratio.
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Debt ratio
The debt ratio measures the proportion of total assets financed by the company's creditors. The higher the index, the greater the amount of other people's money used to generate profits. The index is calculated as follows:
Debt ratio = Total liabilities ÷ Total assets
Debt-equity ratio
The debt-equity ratio measures the relative amount of funds provided by lenders and owners. It is calculated as follows:
Debt-to-equity ratio = Long-term debt ÷ Shareholder capital
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2. The ability to pay debts
It reflects the ability of a company to make the required payments according to what is programmed during the term of a debt. The term debt settlement simply means paying off debts on time. The company's ability to pay certain fixed costs is measured using coverage ratios. High coverage ratios are generally preferred (especially from the lenders' stance), but a very high ratio could indicate that the company's management is too conservative and that it could have higher returns if it applied for more loans. In general, the lower the company's coverage ratio, the less chance it has of paying its fixed obligations. If a company is not able to pay these obligations, its creditors will immediately request the corresponding reimbursements, which,in most cases, it would force a firm to file for bankruptcy. Two frequently used coverage ratios are: the fixed interest charge ratio and the fixed payment coverage ratio.
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Fixed Interest Charge Ratio
The fixed interest charge ratio, sometimes called the interest coverage ratio, measures the firm's ability to make contractual interest payments. The higher its value, the greater the company's ability to meet its interest obligations. The fixed interest charge ratio is calculated as follows:
Fixed interest rate ratio = Earnings before interest and taxes ÷ Interest
Fixed payment coverage ratio
The fixed payment coverage ratio measures the company's ability to meet all of its fixed payment obligations, such as interest and principal on loans, lease payments, and preferred stock dividends. As with the ratio of fixed interest charges, the higher the value of this index, the better. The formula to calculate the coverage ratio of fixed payments is:
Fixed payments coverage ratio = (Earnings before interest and taxes + lease payments) /
Interest + Lease payments + {(Principal payments + Preferred stock dividends) *}
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In the following video-lesson, Professor Sotero Amador Fernández, from CEF, clearly explains what the financial reasons for indebtedness are, what they measure, what information they provide and what are the advantages and disadvantages of high or low leverage.
Bibliography
- Gitman, Lawrence J. and Zutter, Chad J. Principles of Financial Management. Pearson Education, 2012.Gitman, Lawrence J. and Joehnk, Michael. Investment fundamentals. Pearson Education, 2009.
