Topic:
What are debt ratio and times interest ratio? Where they are used?
Professor Guidance:
The amount of the debt a company carries on its balance sheet and its interest payment obligations are of major consequence for the health and solvency of the company. In this wee LE we discuss those.
by Yo Han Song“>Yo Han Song
The debt ratio informs the proportion of assets financed with debt. A debt ratio of 0.50 means that debt finances half the assets. The higher the debt ratio, the more significant the pressure to pay interest and principal. The debt ratio is a degree of solvency. In general, a debt ratio of less than 30% suggests a company isn’t as efficient as it could be. In contrast, a ratio of more than 75%, let’s say, indicates possible bankruptcy if a company experiences a downturn in business. The debt ratio is calculated as total liabilities divided by total assets. It tells us what percentage of assets are financed with debt. Most debt ratios are around 60% on average, as businesses tend to invest more assets with debt than equity. This is largely because of debt tax advantages. Interest expense is tax-deductible for companies. Here is the asset section of a Balance Sheet. We’ll use the highlighted total assets to determine the debt ratio. And here’s the liabilities section of the Balance Sheet. We’ll use the highlighted total liabilities to resolve the debt ratio. So for 2015, total liabilities divided by total assets give us a debt ratio of 38.6%. In 2016, total liabilities divided by total assets provided us with a debt ratio of 17.2% (Federal Reserve Bulletin 2017). These ratios are low, which is safe because it means the company should make its debt payments, even during economic downturns. But it also means this company isn’t as efficient or profitable as it could be because it is not using leverage to increase profits. To learn more about influence, check out the video called “equity multiplier.”
Federal Reserve. (2017, September). Federal Reserve Bulletin. Federal Reserve. Retrieved November 2021
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by Jana Kmetova
Debt ratio is a leverage ratio (measures a company’s ability to sustain operations indefinitely by comparing debt levels with equity, assets, and earnings) that estimates its liabilities as a percentage of its sum assets. Effortlessly, the debt ratio shows how many assets a company has to sell to have zero liabilities. If a company has a high level of liabilities, the riskier it is for lenders compared to its assets. The amount of debt ratio usually helps investors show big is the burden of the company they would like to invest in. When the debt ratio is calculated, it is vital to count all liabilities and all assets of the company. Most of the debt ratio result in decimal because, as mentioned above, it is calculated in percentages. Each company has its own landmarks for debt, but 0.5 is the most common ratio. Any amount lower than 0.5 means that a company is less risky. In other words, liabilities are less than 50% of the whole company’s assets. If the debt ratio is 1, the amount of the liabilities and assets is the same, so the company has to sell all assets to cover its liabilities. For instance, a company, CASD, would like to build up one more storage. The CEO goes to the bank to sign up for a loan. The bank asks what liabilities are and what are assets of CASD company. The CEO says – liabilities are $ 25.000, and assets are $ 100.000. The result is that the debt ratio is 0.25, which is a low debt ratio (My accounting course, 2021).
The time interest ratio is a ratio that measures the time frame that a company needs to pay its liabilities to meet its debt obligation regularly is. This ratio shows how many times it could company pay its interest expenses to devote all its repayments. The main purpose is to show the company’s profitability of default. This means if the Time interest ratio is higher, the better health the company has. However, too high a time interest ratio signalized that company does not make any investments and keeps all its earnings without any development. This can mean that company is facing a lack of profitability and growth in the long term (CFI, 2021).
References:
My accounting course. (2021). Debt Ratio, https://www.myaccountingcourse.com/financial-ratios/debt-ratio
CFI. (2021). What is the Times Interest Earned Ratio?, https://corporatefinanceinstitute.com/resources/knowledge/finance/times-interest-earned/
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