19 May 2012

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Debt Ratios

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Written by Sunil Tinani

These ratios help determine if the company has borrowed more than its means. There are three key ratios to understand:

1. Debt Ratio

Debt Ratio = Total Debt ÷ Total Assets

A greater than 1 debt ratio indicates that the company has borrowings that are not covered by all its assets. This is a risky prognosis.

2. Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Debt ÷ Total Equity

A score of over 1 indicates that the company has borrowed more than the share capital and free reserves available. This means that the company is confident of raking in enough sales/profits to cover the interest charges several times over. When you arrive at a high Debt-to-Equity Ratio, you must check the Interest Cover Ratio.

3. Interest Cover Ratio

Interest Cover Ratio = EBIT (earnings before interest and taxes) ÷ Interest paid by the company

If a company makes an EBIT that covers the interest paid several times, then the company is going great guns; if the EBIT barely manages to cover the interest, then the company is either not working to an optimum plan, or is facing trouble.

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