Looking at financial health of a company using debt ratios

A company can fund its operations and growth by using equity and debts. There are some debt ratios available that investors and analysts use to do a simple check into the financial health of a company. I shall provide a simple discussion on a few debt ratios with their uses and any limitations.

Debts is part and parcel of a company's capital structure. It is uncommon to find a company totally without any form of debts. However, there exists highly profitable companies (though the minorities) that do not require debts funding but all funding for the operations and growth of the company can be provided for by its retained earnings. Such excellent companies also boast of consistent high amounts of free cashflows in their accounts. As such, they employ minimal or no debts in funding their operations and growth. It is important to know where a company stands in terms of its amount of debts. A company that employs high amount of debts may run the risk of not being able to pay its debts when due and thus result in possible risk of bankruptcy.

To ascertain whether a company is financially healthy and is not employing a high debt load and burden, debt ratios are commonly used. To understand the use of such debt ratios, we need to first look at the two types of liabilities a company can incur. These two types are operational and debt liabilities. Liabilities falling under operational type include accounts payable, taxes payable and any forms of operating expenses. Liabilities falling under debts nature include notes payable, and any forms of short-term borrowings and long term borrowings.

Debt-Equity Ratio

Debt-equity ratio compares the total liabilities to shareholders' equity of a company. It reveals how much leverage a company engages. There is no hard and fast rule to tell whether a company is excessively leveraged. However, if a company is consistently more significantly leveraged to its similar competition in an industry, it may be a potential red flag for the company.

In looking at debt-equity ratio, the lower the ratio the better the financial health of a company. A lower ratio means lower total liabilities compared to the equity of a company. In using this ratio, one is considering the total liabilities which include both operational and debts liabilities. So, this ratio provides only a general look into all liabilities carried by the company compared to its equity. It does not focus on only the debts portion alone but also include other operational liabilities as well.

Capitalisation ratio

Capitalisation ratio provides a look into the amount of debts carried in a company's capital structure.

As capitalisation ratio considers only the debts portion compared to the total capital structure (capital raised by lenders and shareholders), it provides a more meaningful look into the composition of a company's capital structure. A lower capitalisation ratio indicates better financial position for a company.

Interest coverage ratio

Interest coverage ratio measures how easily a company can pay its interests on outstanding debts.

An interest coverage ratio of at least 1.5 or more is preferred. A lower interest coverage ratio may suggest that a company is taking on a high amount of interest expenses from a high amount of debts. A high interest coverage ratio also means a company has the capacity to further take on larger amount of debts (e.g. for expansion and growth opportunities) when required.

Cashflow to debt ratio

Cashflow to debt ratio provides a comparison between the operating cashflow and the total debts of a company. The total debts of a company will include short-term borrowings, current portion of long term debts and non-current portion of long term debts. This ratio seeks to measure how much the cash generated from operations can cover all total debts of a company.

Sometimes, free cashflow can also be used to substitute operating cashflow in the calculation. This will provide a more stringent measurement of the ability of the free cashflow generated by a company to cover its total debts. A high cashflow to debt ratio is preferred as it suggests the ability for the cashflows of a company to cover its total debts.

Conclusion

Debt ratios generally provide a look into the amount of debts carried by a company and measures the ability of a company to carry its debts at a financially healthy level. Almost all companies will carry different amounts of debts. Companies in different industries may also carry very different amount of debts. One should compare similar companies in an industry when using such financial ratios as the capital structure of companies in different industries may differ widely. Nevertheless, debt ratios help an investor to check for any potential warning signs on the financial health of a company. When assessing a company, amount of debts carried is only one component to look at. To have a better assessment of a company, an investor should look at the company holistically in many aspects, not just its capital structure alone.