Debt Ratios

A company's ability to survive over the long term, which is related to its debt position, is measured by these ratios. The debt position of a firm indicates the amount of non-owner or non-self-generated funds used by the business. In general, the more debt a firm uses, the higher the risk. Due to the influence of financial leverage, debt could actually increase the return to owners but at the risk of possible insolvency should the company not be able to service its debt.

Debt is part and parcel of the way modern companies are financed. As long as the margin of safety provided by its own funds is sufficient and the company is able to meet its debt-related obligations there is no reason why debt could not be used. The only proviso is that the company must earn more with the borrowed funds than the cost thereof, that is positive financial leverage.

Debt ratio:

= total liabilities ÷ total assets

= R10 000 000 + R10 700 000 ÷ R31 000 000

= 0.668 or 66.8%

Industry norm 47.7%

For each rand invested in assets, R0.66 was financed by debt. Put differently, only R0.34 of each rand invested in assets belongs to the owners.

Times interest earned (TIE)

= Earnings before interest and tax ÷ Interest paid

= R4 000 000 ÷ R1 000 000

= 4 times

Interest is covered more than 2.4 times the industry norm. Note that when TIE equals 1, net income before tax is zero. Although Jimco's debt ratio seems to be on the high side, interest payments should easily be met, as indicated by the TIE ratio.

Note that these two ratios should always be judged together. A company can have a fairly low (good) debt ratio and a very low (bad) TIE ratio and vice versa.

Click here to view a video that explains Financial Analysis Debt Ratio.