Week 4 Debt Utilization Ratios

Week 4: Lecture

Debt Management Ratios

As mentioned previously, these types of ratios measure the riskiness of the firm's income.   The terms "debt" and "liabilities" are sometimes used interchangeable--see note below!

Ratio Formula
Debt to Total Assets Ratio, or Debt Ratio Total Liabilities
Total Assets
  For Amalgamated Hat Rack in 2016: 1,676,000
3,461,000		 = .484 or 48.4%
 

If the industry average was 30% we would be worried about Amalgamated Hat Rack.

      
  Note: The calculation of a company’s debt ratio can vary among financial analysts depending on what is defined as debt. Here we defined debt as being equal to total liabilities, or all financing that comes from a source that must be paid back. Other’s, however, would argue that such liabilities as accounts payable are spontaneously generated when the firm buys supplies on credit and do not represent debt in the classic sense. These analysts define debt as those liabilities which represent money that was borrowed and must be paid back with interest (this is sometimes called interest-bearing debt). If debt is defined as interest bearing debt only, then the debt ratio is: Interest Bearing Debt
Total Assets
  Note: Interest bearing debt generally consists of notes payable plus long-term debt.  
Times Interest Earned (TIE) Earnings Before Interest and Taxes (EBIT)
Interest Expense
  For Amalgamated Hat Rack in 2016: 757,500
110,00		 = 6.9x
 

Note that Amalgamated Hat Rack's income-before-interest (EBIT) could drop by $647,500, or 85%, and Amalgamated Hat Rack could still make its interest payments (757,500 - 110,000)

       

 

Equity-Capital Ratio (EC)      Total Owners' Equity    
Total Assets
  For Amalgamated Hat Rack in 2016: 1,785,000
3,461,000		 = 51.6%
 

Note that Amalgamated Hat Rack's Debt Ratio + its Equity-Capital Ratio equal 1 or 100%, since Total Assets = Total Liabilities + Owners' Equity on the Balance Sheet.

      

 

Debt-to-Equity Ratio (D/E)      Total Debt    
Total Liabilities
  For Amalgamated Hat Rack in 2016: 1,676,000
1,785,000		 = 93.9%
 

In Amalgamated Hat Rack's capital structure, as we saw before based on the DR and EC ratios, there is almost as much debt as owners' equity.