Debt ratios
/What are Debt Ratios?
Debt ratios measure the extent to which an organization uses debt to fund its operations. They can also be used to study an entity’s ability to pay for that debt. These ratios are important to investors, whose equity investments in a business could be put at risk if the debt level is too high. Lenders are also avid users of these ratios, to determine the extent to which loaned funds could be at risk. Debt ratios are a particular concern when a business wants a credit rating agency to give a rating to one of its debt securities; if the ratios reveal a high debt load, a rating agency may assign a low rating that increases the interest cost of the securities to be sold. The key debt ratios are noted below.
Related AccountingTools Courses
The Interpretation of Financial Statements
Debt to Equity Ratio
The debt-to-equity ratio measures a company's financial leverage by comparing its total debt to its shareholders' equity. A high debt-to-equity ratio indicates that a company relies more on debt financing, which can increase financial risk but also boost returns if managed effectively. Conversely, a low debt-to-equity ratio suggests a more conservative capital structure, relying more on equity financing, which may reduce risk but could also limit growth potential. Investors and creditors use this ratio to assess a company's financial stability and ability to handle debt obligations. The formula is as follows:
(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio
Debt Ratio
The debt ratio is a financial metric that measures the proportion of a company's assets financed by debt. A higher debt ratio indicates that a company relies more on borrowed funds, which may increase financial risk but can also enhance returns if the borrowed capital is used effectively. Conversely, a lower debt ratio suggests that a company is less dependent on debt and may have greater financial stability, but it could also mean the business is not taking advantage of leverage to fuel growth. The formula is:
Total debt ÷ Total assets = Debt ratio
A variation on the debt formula is to add all liabilities to the numerator, including accounts payable and accrued expenses.
Debt Service Coverage Ratio
The debt service coverage ratio measures a company's ability to cover its debt obligations using its operating income. It is calculated by dividing net operating income by total annual debt payments, including both principal and interest. A ratio greater than 1.0 indicates that a company generates enough income to meet its debt payments, while a ratio below 1.0 suggests potential financial difficulty in covering obligations. Lenders and investors use the debt service coverage ratio to assess a company's financial health and creditworthiness, especially when evaluating loan applications or investment risks. The formula is as follows:
Net annual operating income ÷ Total of annual loan payments = Debt service coverage ratio
For more accuracy, reduce the total debt service figure by the beneficial effect of the deductibility of interest payments on income taxes.
Interest Coverage Ratio
The interest coverage ratio measures a company's ability to meet its interest payments on outstanding debt. A higher ratio indicates strong financial health, meaning the company generates enough earnings to comfortably cover its interest obligations. Conversely, a lower ratio (especially below 1.5) signals potential financial distress, as the company may struggle to pay interest, increasing the risk of default or bankruptcy. The calculation is as follows:
Earnings before interest and taxes ÷ Interest expense = Interest coverage ratio
Trend Line Analysis
It is useful to plot these measurements on a trend line. Doing so reveals the existence of any issues where the debt load of an entity is increasing over time, or where its ability to repay debt is declining.