Debt Ratio Analysis As A Tool Of The Company’s Financial Sustainability Measurement
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Debt Ratio Analysis As A Tool Of The Company’s Financial Sustainability Measurement

One of the indicators of the company’s financial health is its ability to carry its debt. In the long run this means the ability of a firm to meet its long-term obligations upon the request of creditors without a risk of becoming a bankrupt. It can be measured by performing the debt ratio analysis, one of the stages of the financial statement analysis of the company. It requires the access to the company’s major financial statements, such as the balance sheet and income statement. Normally, knowing more about the financial sustainability of the firm is important for the company’s owners since this gives them a chance to predict possible financial problems in future and take some measures to avoid them. It is also useful for the firm’s potential investors since it allows them to make some judgements on the creditworthiness of the business.

Performing the debt ratio analysis includes computation and interpretation of a set of indicators (financial ratios). Doing this allows to make some important conclusions on the company’s current financial condition and performance. Key ratios of the debt ratio analysis are the times interest earned (also referred as the interest coverage ratio), the debt ratio, the debt to equity ratio, the long-term debt to total capitalization ratio, etc. Let us have a closer look at some of them.

Times Interest Earned (Interest Coverage Ratio) is one of the main indicators of the firm’s financial sustainability. It can be computed through dividing the company’s EBIT (earnings before interest and taxes) by the total interest expense. This ratio measures the firm’s long-term debt-paying ability from the statement of income view. High and stable interest coverage ratio indicates the good financial condition of the company, while low and fluctuating ratio means the firm has some problems with its debt-paying ability.

Debt ratio can be calculated by dividing the total liabilities of a firm by its total assets. The higher the ratio, the more dependent on debt the company is, which means higher risk of not being able to meet its obligations.

Debt to equity ratio is a measurement of the firm’s ability to pay its debt involving only the stockholders’ equity. This ratio is an indicator of the creditors protection level in case of the firm’s insolvency. The calculation of this ratio can be done through dividing the total liabilities of the company by the total shareholders’ equity. Higher ratio means higher financial leverage for a firm, which most commonly means higher risk for an investor.

The long-term debt to total capitalization ratio measures the firm’s financial leverage. In other words, it shows how actively the company is financing its operations with the long-term debt. This ratio can be computed by dividing the long-term debt by the sum of long-term debt and stockholders’ equity. The decrease of this ratio indicates the company’s declining long-term debt load comparing to the total capitalization.

Should be mentioned that the ratios for one single period can not be a base for a complete analysis. It is important to calculate and compare the same ratios for different periods. For more precise conclusions, the ratios should also be compared to the major similar-sized competitors and to the industry averages.

Considering everything said, regular and quality debt ratio analysis is vital for the firm since it allows to estimate the financial sustainability of the business and make proper decisions. Performing the debt ratio analysis is easy with online services like Finstanon, which allow you to simply enter the financial statement data to the website and get a detailed analytical report on your company's financial condition and performance.


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