Debt to equity shows the ratio between capital invested by the owners and the funds provided by lenders. It compares how much of the business was financed through debt, and how much was financed through equity. For this calculation, it is common practice to include loans from owners in equity rather than in debt. The higher the ratio, the greater the risk to a present or future creditor. Look for a debt to equity ratio in the range of 1:1 to 4:1.
Most lenders have credit guidelines and limits for the debt to equity ratio. Too much debt can put your business at risk, but too little debt may mean you are not realizing the full potential of your business. This may actually hurt your overall profitability, and is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate). Long-term debt to assets is the ratio of long-term liabilities (those that won’t be paid off in one year) to total assets.
The higher the level of debt, the more important it is for a company to have positive earnings and steady cash flow. Assets are also important to consider because they can be a cushion against losses in the event of liquidation. Debt is not “bad,” but since it requires the timely payout of interest to debt holders, it is important to analyze a company within the context of the likeliness that it will have adequate resources to meet its payments in the event of major losses.
The interest coverage ratio is a measurement of the number of times a company could make its interest payments with its earnings before interest and taxes; the lower the ratio, the higher the company’s debt burden. For bondholders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company’s earnings can fall before it will start defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business.
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. Nike, Inc. is in good financial condition. Revenues and net income are on the rise, and the company is out-performing its competition. Evidence of this is contained in these financial highlights retrieved from Mergent Incorporated.
