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Debt Management Ratios

Debt Management Ratios

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Author: Sophia Media
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Interpret the ratios that determine how effectively a company can handle its debt.

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[MUSIC PLAYING] This is Dr. Bob Nolley with a lesson on debt management ratios. Debt management ratios measure a firm's ability to repay its long-term debt. Two ratios that will be discussed today are the debt ratio and the times interest earned ratio. The debt ratio is a financial ratio that indicates the percentage of a company's assets that are provided by debt. It is the ratio of the total debt, which is the sum of the current liabilities and the long-term liabilities, divided by the total assets.

The higher this debt ratio, the greater the risk is with this firm's operations. Additionally, high debt ratios may indicate a low borrowing capacity of the firm. This in turn will lower the firm's financial flexibility. Like all the other ratios, a debt ratio should be compared with their industry average or with that of the competition. Let's take a look at an example.

Here we are with ABC Company. The total assets are $27,426. The total liabilities are $12,409 for the current liabilities and $3,450 for the long-term liabilities for a total of $15,859. If we divide the total liabilities by the total assets, we get $0.58. This means that 58% of ABC's assets are financed by debt rather than by equity. Upon comparison, we may find that this is high and may limit their financial flexibility and borrowing power.

The second debt management ratio is the times interest earned ratio. The Times Interest Earned or the TIE measures the company's ability to honor its debt payments. This is also sometimes called the interest coverage ratio. It is calculated by dividing the EBIT or the Earnings Before Interest and Taxes by the interest charges. It's a great tool when measuring a company's ability to meet its debt obligations.

Typically, it's a warning sign when the interest coverage falls below 2.5. When the times interest earned is less than 1, the company is not generating enough cash from operations to meet its interest obligations. The company would either have to use cash on hand to make up the difference or borrow funds. Let's look at an example.

In this simple example, we are looking for the earnings before interest and taxes. And that number here is the operating income of $9,060,000. The interest expense is $1,610,000. If we divide $9,060,000 by the $1,610,000, we get 5.62. So in this example, this company is in fairly good shape in terms of its interest coverage.

Here are some key takeaways on the debt management ratios. The debt ratio comes from the firm's ability to repay its long-term debt by indicating what percentage of the company's assets are provided by debt calculated by the total liabilities divided by the total assets. The higher the ratio, the greater the risk associated with the operation.

Times Interest Earned or TIE is a measure of the company's ability to pay its payments. It could be calculated as earnings before interest and taxes divided by the total interest payable. Times interest earned, also called interest coverage, is a great tool when measuring the company's ability to meet those obligations. This is Dr. Bob Nolley, and I'll see you in the next lesson.

[MUSIC PLAYING]

Terms to Know
Debt Ratio

A ratio that indicates the percentage of a company's assets that are provided by debt.

Times Interest Earned Ratio

A ratio that measures the company's ability to honor its debt payments.

Formulas to Know
Debt Ratio

D e b t space R a t i o equals fraction numerator T o t a l space L i a b i l i t i e s over denominator T o t a l space A s s e t s end fraction

Times Interest Earned Ratio

T i m e s space I n t e r e s t space E a r n e d space R a t i o equals fraction numerator E B I T over denominator I n t e r e s t space E x p e n s e end fraction