Debt management ratio

Debt management ratio
See also
Capitalization ratio Debt to total assets ratio Solvency ratios Capitalization ratios Coverage ratio Liquid net worth Asset equity ratio Free cash flow yield Current portion of long-term debt

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

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

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