Leverage Measures: Debt-Equity Ratios and Fixed-Charge Coverage Ratio

The amount of a company's debt 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 Great Recession of 2007 and 2008, when even short-term debt couldn't even be refinanced. Indeed, the Great Recession as 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 following ratios measure a company's solvency, because they measure the ability of a company to meet its long-term obligations, so they are often called solvency ratios. By contrast, liquidity ratios, such as the current and quick ratios, measure a company's ability to meet short-term obligations.

Debt-Equity Ratios

The debt-equity ratio measures the proportion of funds provided by creditors and stockholders. There are different versions of this ratio that differ mostly in the numerator. Higher values of any of the following ratios indicates greater risk for the company and its stockholders.

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.

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.

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, the ratio of short-term and long-term debt plus preferred stock over total equity:

The total debt ratio, also known as the debt-to-assets ratio, measures the company's assets financed with debt:

For instance, a debt-to-assets ratio of 35% shows that 35% of the company's assets are financed with debt.

The debt-to-capital ratio measures how much of a company's capital, = total debt + total equity, is represented by debt:

The financial leverage ratio, often simply called the leverage ratio, quantifies the total assets supported by each monetary unit of equity:

For instance, a ratio of 10, which is typical for banks, indicates that each $1 of equity supports $10 of assets. Before its demise, Lehman Brothers had a leverage ratio of 33 — extremely high, even for a financial institution.

Fixed-Charge Coverage Ratio (aka Times Interest Earned)

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 expenses 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 and taxes (EBIT) divided by the interest expense of long-term debt and other liabilities.

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 use EBIT rather than EBITDA in calculating the fixed-charge coverage ratio.