Debt management ratio

Debt management ratio - Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid financial distress in the long run. These ratios are also known as Long-Term Solvency ratios. Debt is also called financial leverage, because the use of debt can improve returns to stockholders in good years and increase their losses in bad years. Debt management ratios indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders. Ratios tend to focus on short-term and long-term solvency respectively, i.e. the more financial management side of an undertaking relating to assets and liabilities, represented by the balance sheet.

Effects of use debt management ratio

Here are three important effects:

• stockholders can control a firm with smaller investments of their own equity if they finance part of the firm with debt,
• if the firm's assets generate a higher pre-tax return than the interest rate on debt, then the shareholders' return are magnified, or leveraged. Inversely, shareholders' losses are also magnified is assets generate a pre-tax return less that the interest rate,
• if a company has high leverage, even a small decline in performance might cause the firm's value to fall below the amount it owes to creditors. Therefore, a creditor's position becomes riskier as leverage increases.

Types of ratio

Here are types of debt management ratios:

• Debt-to-assets Ratio - shows how much of asset base is financed with debt. Total debt includes all current liabilities and long-term debts. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors' losses in the event of liquidation. Main thing to remember is that if 100% of company's asset base is financed with debt, company is bankrupt.

$Debt-to-assets\ ratio=Debt\ ratio={\frac {Total\ debt}{Total\ assets}}$

• Debt to equity ratio - shows how much company has of debt for every dollar of equity, this ratio is widely used.

$Debt-to-equity\ ratio={\frac {Total\ debt}{Total\ common\ equity}}$

• Market debt ratio - reflects a source of risk that is not captured by the conventional debt ratio

$Market\ debt\ ratio={\frac {Total\ debt}{Total\ debt\ +\ Market\ value\ of\ equity}}$

• Liabilities-to-assets ratio - shows the extent to which a firm's assets are not finances by equity

$Liabilities-to-assets\ ratio={\frac {Total\ liabilities}{Total\ assets}}$

• Times-interest-ratio - called the interest coverage ratio is determined by dividing earnings before interest and taxes by the interest expense

$Times-interest-ratio={\frac {EBIT}{Interest\ expense}}$

Examples of Debt management ratio

• Debt to Equity Ratio: This ratio measures the percentage of debt a company is using to finance its assets relative to the amount of equity it has. The higher the ratio, the more debt a company has relative to equity, and the more at risk it is of financial distress.
• Interest Coverage Ratio: This ratio measures a company's ability to meet its interest payments. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses. The higher the ratio, the more likely a company will be able to meet its interest payments in the long run.
• Times Interest Earned Ratio: This ratio measures a company's ability to pay its interest expenses. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses. The higher the ratio, the more likely a company will be able to meet its interest payments in the long run.
• Cash Flow to Debt Ratio: This ratio measures a company's ability to pay its debts using its cash flow. It is calculated by dividing a company's cash flow from operations by its total debt. The higher the ratio, the more likely a company will be able to pay its debts in the long run.

Advantages of Debt management ratio

Debt management ratio is a valuable tool for assessing a company's ability to manage its debt load. It provides insight into the firm's creditworthiness and ability to remain financially healthy over the long-term. Here are some advantages of using debt management ratios:

• Enhanced Creditworthiness - A low debt management ratio indicates that a company is able to manage its debt load efficiently, which in turn enhances its creditworthiness. This can help a company secure additional financing from banks and other financial institutions.
• Reduced Financial Risk - A low debt management ratio also reduces the financial risk for a company as it indicates that the company is not heavily laden with debt. This reduces the possibility of the company defaulting on its debt obligations.
• Improved Profitability - A low debt management ratio indicates that the company is not spending too much on interest payments and borrowing costs. This leaves more resources available for reinvestment and expansion, which can lead to improved profitability over the long-term.
• Improved Shareholder Returns - A low debt management ratio can also lead to improved shareholder returns as the company is able to generate higher profits without taking on excessive debt. This can lead to higher dividends and increased stock prices.

Limitations of Debt management ratio

• Ignores the Cost of Debt: Debt Management Ratios do not take into account the cost of the debt, which can impact the financial health of the firm.
• Timing of Debt Repayment: The Debt Management Ratios do not take into account the timing of the debt repayment, which can have a big impact on the long-term solvency of the firm.
• Interest Rate Risk: Debt Management Ratios do not take into account the interest rate risk associated with taking on debt. This can lead to an overestimation of the firm's long-term solvency.
• Current vs. Long-Term Debt: Debt Management Ratios primarily focus on long-term debt and do not take into account the current debt the firm may have, which can have a significant impact on the firm's ability to repay its debt.
• Ignores Other Forms of Financing: Debt Management Ratios do not take into account other forms of financing such as equity or venture capital, which can also affect the firm's financial health.
• Ignores Operating Cash Flow: Debt Management Ratios do not take into account operating cash flow, which is an important factor in a firm's ability to service its debt.

Other approaches related to Debt management ratio

• Debt-to-Equity Ratio: This is a measure of how much debt a company is carrying relative to its total equity. It is calculated by dividing total liabilities by total equity.
• Interest Coverage Ratio: This is a measure of a company’s ability to service its debt obligations. It is calculated by dividing operating income by total interest expense.
• Cash Flow to Debt Ratio: This is a measure of a company’s ability to meet its debt obligations using cash generated from operations. It is calculated by dividing the sum of cash flow from operations and changes in working capital by total debt.
• Debt Service Coverage Ratio: This is a measure of a company’s ability to service its debt obligations using cash generated from operations and income taxes. It is calculated by dividing the sum of cash flow from operations, income taxes, and depreciation and amortization by total debt.

In summary, debt management ratios provide a measure of a company's financial leverage and ability to avoid financial distress in the long term. These ratios help investors and creditors assess the risk of investing in a company and whether the company is able to service its debt obligations.

Debt management ratio — recommended articles

Capitalization ratio — Ebitda ratio — Asset equity ratio — Capitalization ratios — Degree of financial leverage — Capital gearing — Debt to total assets ratio — Solvency ratios — Asset coverage ratio

References

• Brigham E.F., Ehrhardt M.C., (2013) Financial Management: Theory & Practice, Cengage Learning, South-Western,
• Brigham E.F., Joel F. Houston J.F., (2012), Fundamentals of Financial Management, Cengage Learning, South-Western,
• Harris P., (1999), Profit Planning, Butterworth-Heinemann, Oxford

Footnotes

Author: Alicja Ficek