Debt Management Ratios

Is a firm uses debt financing such as by raising funds through debt, creditors look to the equity, and the return on the owners' capital.

The extent to which a firm uses debt financing, or financial leverage, has three important implications: (1) By raising funds through debt, its owners can maintain control of a firm with a limited investment. (2) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety; if the owners have provided only a small proportion of the total financing, the risks of the enterprise are borne mainly by its creditors. (3) If the firm earns more on investments financed with borrowed funds than it pay in interest, the return on the owners' capital is magnified, or leveraged. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds. 

        Debt ratio   =    Total Debts  

                               Total Assets

Times-interest-earned Ratio (TIE) is measures the ability of the firm to meet its annual interest payments.

        TIE ratio   =    Earnings Before Interest and Taxes (EBIT)  

                                              Interest Expenses

A high coverage ratio tells the firm's shareholders and lenders that the likelihood of bankruptcy is low because annual earnings are significantly greater than annual interest obligations. It is widely used by both lenders and borrowers in determining the firm's debt capacity and is a major determinant of the firm's bond rating.

Fixed Charge Coverage Ratio

=                                EBIT + Lease Payments                            

     Interest Expenses + Lease Payments +  Sinking Fund Payments  

                                                                  ( 1 – Tax Rate )

EBITDA means earnings before interest, taxation, depreciation and amortization. It was became a very popular measure of a company's performance especially with managers of firms that failed to make a profit. Managers liked to emphasize this measure in their communications to stockholders because large positive numbers could be shown.

The use of EBITDA by company directors makes political spin doctors look amateurs by comparison. EBITDA is not covered by any accounting standards, so companies are entitled to use a variety of methods - whatever shows the company in the best light.