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Saturday, 15 June 2013

Debt Ratios

Also known as Leverage Ratios or Solvency Ratios. Debt Ratios measure the stability of a company and its ability to repay debt. The five most commonly used Debt Ratios are explained below.

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

1) Debt Ratio

The debt ratio compares a company's total debt to its total assets, it gives an idea to the level of leverage used by the company along with the potential risks the company faces in terms of its debt-load. The higher the ratio, the higher the risk is considered to be taken on by the company. A low ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk.

Formula : Debt Ratio = Total Liabilities / Total Assets

Benchmark : A ratio of less than 0.5 is desirable. Generally, large and well established companies can take on higher percentage of debt component in their balance sheet without getting into trouble. Growth companies which can generate returns above the cost of capital are able to take on more leverage.

Note : This ratio is not a pure measure of a company's debt as it includes also operational liabilities which are used to fund the day-to-day operations of the business. The operational liabilities such as accounts payable and taxes are not really debts in the leverage sense.

Calculation : The Debt Ratio for Cisco as at 28 Jul 2012 is 40,473 / 91,759 = 0.44.

2) Debt-Equity Ratio

The debt-to-equity ratio (D/E) indicates the relative proportion of shareholders' equity and debt used to finance a company's assets. It compares the total liabilities to shareholders' equity as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the means that a company is using less leverage and has a stronger equity position. If the ratio is less than 1, most of the company's assets are financed through equity and if the ratio is greater than 1, most of the company's assets are financed through debt.

Formula : Debt-Equity Ratio = Total Liabilities / Shareholders' Equity

Benchmark : A ratio of less than 1 is desirable. This ratio also depends on the industry in which the company operates. Generally, companies in the capital-intensive industries tend to have higher debt/equity ratio than companies in the non-capital-intensive industries.

Calculation : The Debt-Equity Ratio for Cisco as at 28 Jul 2012 is 40,473 / 51,286 = 0.79.

3) capitalization Ratio

Capitalization Ratio is a measurement of a company's financial leverage, calculated as the company's long-term debt divided by its total capital. Total capital includes the company's long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios as it delivers the key insight into a company's use of leverage.

Formula : Capitalization Ratio = Long-Term Debt / (Long-term Debt + Shareholders' Equity)

Benchmark : There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality.

Calculation : The Capitalization Ratio for Cisco as at 28 Jul 2012 is 16,297 / (16,297+51,286) = 0.24.

4) Interest Coverage Ratio

Interest Coverage Ratio is used to determine how easily a company can pay interest expenses on its outstanding debt. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.

Formula : Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Benchmark : A ratio of 1.5 is often cited as the standard minimum level for a viable business. This level might have to be adjusted at times depending on the type of business being analyzed. If a business has a steady income flow, then the ratio doesn't need to be extremely high to sustain. A company in an industry that experiences high volatility would probably need a higher interest coverage ratio to withstand the fluctuations.

Calculation : The Interest Coverage Ratio for Cisco as at 28 Jul 2012 is 10,755 / 596 = 18.05.

5) Cash Flow to Debt Ratio

This ratio compares a company's operating cash flow to its total debt, it shows the ability of a company to pay its debt from the cash it generates from its operations.. A higher ratio is seen to be evidence that the company is financially healthy, whereas a lower cash flow is indicative of low revenues or high dependence on credit.

Formula : Cash Flow to Debt Ratio = Operating Cash Flow / Total Debt
Where Total Debt = Long-Term Debt + Short-Term borrowing + Current portion of Long-Term Debt.

Benchmark : Normally, you want to see this ratio above 0.66 - the higher, the better. However, this ratio is more helpful when you compare it with historical data to see how has the ratio changed over the past five years or more? Is it becoming higher or lower? Another useful comparison is against the ratios of other companies in the same industry. Some capital-intensive industries may have a lower cash flow to debt ratio than other industries.

Note : Companies with low cash flow to debt ratios need to be looked at carefully, especially, in difficult economic times cash flow can suffer, but debt doesn't go down. The larger the ratio, the better a company can weather rough economic conditions.

Calculation : The Cash Flow to Debt Ratio for Cisco as at 28 Jul 2012 is 11,491 / (31+16,297) = 0.70.

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