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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. 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). Let’s take a look at what they’re used for, how they’re calculated, and how they’re used.
Key Takeaways
- Financial risk ratios are analytical tools that consider a company or investment’s financial health to determine whether the potential for loss is likely.
- 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.
What Are Financial Risk Ratios?
Financial risk ratios are tools that investors, creditors, and analysts can use to determine whether a company or investment is financially unstable—and just how unhealthy it is. These metrics help people understand whether the potential for loss is likely.
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.
Debt-to-Capital Ratio
The debt-to-capital ratio indicates a firm’s financial soundness by measuring leverage. This provides a basic picture of a company’s financial structure in terms of how it is capitalizing its operations. Put simply, the debt-to-ca ratio compares a company’s total short-term debt and long-term debt obligations with its total capital provided by both shareholders’ equity and debt financing.
To determine a company’s debt-to-capital ratio, you’ll need to find its total debt and its shareholders’ equity on its balance sheet, then plug them into the following formula:
Debt-to-Capital Ratio = Debt ÷ (Debt + Shareholders’ Equity)
Let’s say Company X has total debt of $200 million and $300 million in shareholders’ equity. Using the formula above, we can determine that Company X has a debt-to-capital ratio of 0.4 or 40%. This means that 40% of its capital assets are being funded by debt.
Lower debt-to-capital ratios are preferred because they indicate a higher proportion of equity financing to debt financing.
Debt-to-Equity (D/E) Ratio
The debt-to-equity ratio 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-to-Equity Ratio = Debt ÷ Shareholders’ Equity
Using the figures from the example above, we can determine that Company X has a D/E ratio of about 0.67 or 67%.
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 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. This ratio value reveals the number of times a company can make the required annual interest payments on its outstanding debt with its current earnings before interest and taxes (EBIT).
Interest Coverage = EBIT ÷ Interest Expense
Assume Company X has interest expenses of $100 million and EBIT of $200 million. Plugging the numbers into the formula, we can see that it has an interest coverage ratio of 2.
A relatively lower coverage ratio indicates a greater debt service burden on the company and a correspondingly higher risk of default or financial insolvency. Put simply, it means there’s a lower amount of earnings available to make financing payments, so the company is less able to handle any increase in interest rates.
An interest coverage ratio of 1.5 or lower is generally considered indicative of potential financial problems related to debt service. This is not the case with our Company X example. Keep in mind that an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.
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 provides a more complete assessment of a company’s total risk by factoring in both operating and financial leverage. This leverage ratio estimates the combined effect of 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 a company’s management team identify the best possible levels and the 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.
Why Are Financial Ratios Important?
Financial ratios are analytical tools that people can use to make informed decisions about future investments and projects. They help investors, analysts, and corporate management teams understand the financial health and sustainability of potential investments and companies. Commonly used ratios include the D/E ratio and debt-to-capital ratios.
What’s the Difference Between a Financial Ratio and a Liquidity Ratio?
Financial ratios are analytical tools that can be used to determine how well a company is performing and whether it is financially stable. A liquidity ratio, on the other hand, is a financial metric that indicates whether a company can pay its short-term financial obligations on time without having to raise capital.
What Are Some of the Most Common Income Statement Ratios?
Income statement ratios are financial metrics that are calculated using data from a company’s income statement. Some of the most common types of this class of ratios include earnings per share (EPS), gross profit margin, operating profit margin, and net profit margin.
The Bottom Line
Financial ratios are used in fundamental analysis to help value 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.
