The amount of debt of a company affects its profitability and its ability to grow. Debt also incurs risk for both creditors and stockholders because of the potential for default, especially in hard economic times, since the interest on the debt must be paid regardless of hardships. A high debt load can also increase the future cost of credit for the company since it will be less creditworthy. Since many companies refinance maturing short- and long-term debt by issuing more debt, a worse scenario can occur if the availability of credit declines because of economic turmoil, such as during the credit crisis of 2007 and 2008, when even short-term debt couldn’t even be refinanced. Indeed, the credit crisis has forced many companies into bankruptcy.
Of course, the amount of debt by itself is not a useful guide in selecting companies, since it must be compared to the company’s profit and stockholders’ equity to be a meaningful gauge of a company’s solvency.
The debt-equity ratio measures the proportion of funds provided by creditors and stockholders. There are at least 3 different versions of this ratio that differ mostly in the numerator. The 1st ratio, often called the debt ratio divides total liabilities by stockholders’ equity. This ratio would be of most interest to bondholders, since it shows how much value there would be in a liquidation of the company.
| Debt Ratio = | Total Liabilities ──────────────── Stockholders’ Equity |
For its fiscal year ending January, 2008, Wal-Mart had total liabilities of $98,906,000,000 and total stockholder equity of $64,608,000,000. Therefore:
Debt Ratio = 98,906 / 64,608 ≈ 1.53
Another debt-to-equity ratio that is commonly used divides long-term debt by stockholders’ equity, which is a measure of the leverage of a company. This ratio disregards current liabilities, since such liabilities are short-term and involve day-to-day operations, such as payroll and interest payments. Long-term debt is used to finance major capital expenditures, such as equipment or buildings, to hopefully increase future revenues and profits which will increase the return on stockholders’ equity.
| Debt-Equity Ratio or Leverage = | Long-Term Debt ─────────────── Stockholders’ Equity |
Extending the above example, Wal-Mart had long-term debt of $40,452,000,000 in 2008. Therefore:
Debt-to-Equity Ratio = 40,452 / 64,608 ≈ 0.63
Another debt-to-equity ratio compares the amount of securities where interest or dividends are paid to common stock.
| Debt-to-Equity Ratio = | Long-Term Debt + Preferred Stock ───────────────────────── Common Stock |
A company must have enough earnings to pay its interest expense; otherwise it will eventually fail. Because earnings rise and fall depending on market and economic conditions, it would be preferable if the company’s earnings were much higher than interest expense in most years; otherwise, investing in the company would incur significant risk when the economy falters, as it always does eventually. The amount of safety desired depends on the stability of the company’s earnings, and how cyclical the company’s sector is. A company whose earnings rise and fall significantly with economic cycles should have a greater margin of earnings over interest payments.
The fixed-charge coverage ratio (aka times interest earned) is earnings before interest (EBIT) plus taxes divided by the interest expense of long-term debt and other liabilities.
| Fixed-Charge Coverage Ratio = | Earnings before Interest and Taxes ─────────────────────────── Interest Expense of Long-Term Debt |
Since interest is a tax-deductible expense, the full amount of earnings can be used to pay interest.
Some firms, in reporting their results, use earnings before interest, taxes, depreciation, and amortization (EBITDA), because it makes the company's financial picture look better than using EBIT, especially if it is a capital-intensive business. This is because depreciation and amortization are accrual charges that reduce earnings, but are not actually paid during the period. Companies argue that this gives a better picture of their cash flow. The problem with using EBITDA is that although depreciation and amortization are not actual expenses during the reporting period, the company will eventually need money to replace their capital goods eventually, so it shouldn't really be considered as money that can be used to cover interest payments except for the short term. Even intangible assets, such as goodwill, can be problematic in ascertaining a company's ability to pay its interest expense. Hence, it is better to stick with using EBIT rather than EBITDA in calculating fixed-charge coverage ratio.
For its fiscal year ending in January, 2008, Wal-Mart earned $22,301,000,000 before interest and taxes, and had an interest expense of $2,103,000,000. Therefore:
Fixed-Charge Coverage Ratio = 22,301 / 2,103 ≈ 10.6