Debt Ratios

Debt ratios are the family of measures that set what a business owes against a stated base, and the base is what separates one member from the next. In the singular, the debt ratio names one of those members, total liabilities over total assets, rather than the family, so the phrase has to be read with its context attached before anything is compared. The bases themselves split two ways. Some are balance sheet stocks read at a single date: total assets, owners’ equity and total capital. The rest are flows measured across a period, which ask whether that period’s earnings or cash covered what fell due in it. No accounting standard fixes which measures belong to the family or how any one of them is worded, and ratios of this kind are calculated from information on financial statements rather than presented on them (SEC, Beginners’ Guide to Financial Statements).

The Members and the Base Each One Divides By

The measures below are the ones in common use, grouped by the kind of base each divides by. Where a document imposes one of these ratios, its own definitions clause governs the wording instead.

read at one date, off the balance sheet
  debt ratio                    total liabilities / total assets
  debt to equity                total liabilities / total equity
  debt to total capitalization  funded debt / (funded debt + net worth)

read across a period, off the earnings or the cash flows
  times interest earned         EBIT / interest expense
  fixed charge coverage         (EBITDA + fixed charges) / (fixed charges + interest expense)
  debt service coverage         cash flow available for debt service / total debt service

The debt ratio divides total liabilities by total assets, and which liabilities belong in that numerator moves the answer off one statement, worked through in debt to asset ratio analysis. Which balances count as borrowings, and how the part falling due inside a year is split off, sit in long-term liabilities. The same two totals the other way up give the asset side reading in asset to liabilities ratio.

Debt to equity keeps that numerator and swaps the base to equity. Because a balance sheet balances, that measure and the assets over equity form are one fact stated twice, the second being the first plus one, an identity worked out in equity multiplier.

Debt to total capitalization puts the borrowings over the sum of those borrowings and equity, so its numerator sits inside its own denominator. While both figures are positive the quotient cannot reach one, which is not true of the other two.

The flow members each widen what has to be covered. Times interest earned divides a period’s earnings before interest and taxes by that period’s interest expense and stops there, the reading in times interest earned ratio. Fixed charge coverage builds its numerator on a period’s earnings before interest, taxes, depreciation and amortization, or EBITDA, and reaches past interest into rent and lease payments, in the shape a federal rule writes out in fixed charge coverage ratio. Debt service coverage reaches instead to the scheduled principal falling due alongside the interest, in debt service coverage ratio.

A Stock Reading and a Flow Reading Are Not Interchangeable

Two figures both called debt ratios can move in opposite directions off one event, so neither is a check on the other.

Refinance the same principal over a longer term at a lower rate. The principal outstanding is where it was the day before, so every stock member reads the same. The interest charged in the coming period falls and the principal scheduled inside that period falls with it, so every flow member reads higher. Nothing about the size of what is owed changed.

The blind spots are opposite too. A stock member counts dollars owed and says nothing about when they fall due or what they cost. A flow member counts one period’s coverage and says nothing about the size of the balance behind it. Neither converts into the other, and none of them is the test for whether a business can cover the whole of what it owes, which is read at fair valuation rather than off carrying amounts, the ground solvency covers.

Where the Wording of a Member Comes From

With no standard fixing the wording, the document that imposes a ratio writes its own, so two documents naming the same member can mean different figures. A federal rule on bank holding companies puts it in one line. Debt-to-equity ratio means the ratio of a company’s total liabilities to a company’s total equity capital less goodwill (12 CFR 252.220(a)(1)). The base there is not plain equity, because goodwill comes out of it first.

A credit agreement takes longer. A revolving credit agreement filed with the Securities and Exchange Commission defines its consolidated funded debt to total capitalization ratio as the ratio of consolidated funded debt to consolidated total capitalization, then defines consolidated total capitalization as the sum of consolidated funded debt plus consolidated net worth, and consolidated net worth as shareholders’ equity or net worth of the company and its subsidiaries on a consolidated basis determined in accordance with GAAP (Nucor Corporation, Credit Agreement). The chain runs past those three. Consolidated funded debt is itself defined as funded debt of the company and its subsidiaries on a consolidated basis, and funded debt is a seven-clause term reaching past borrowed money into the attributed principal amount of capital leases, securitization transactions and synthetic leases, standby letters of credit, and support obligations in respect of another person’s funded debt. That is why a financial covenant carries its own definitions clause and why the agreement rather than the accounting decides what a borrower computes, the ground covenants covers.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own ratio and covenant schedule work through a trial task before a client’s lender ever sees it.