How to Apply Debt Management Ratios

Whether you are an investor or a manager of a firm's business unit, you can analyze financial statements to discover the true health of your investment. Investors need to know how companies use their money to finance operations, which has a direct impact on how much the investor earns on the investment. Analyzing financial statements can also help firm managers compare their operating efficiencies to competitor operations. Are your firm managers making the best use of debt? Calculate debt management ratios to find out for yourself.

Instructions

1. Visit the firm's website to find the set of financial statements. These will usually be found in the "Investors" or "Company Information" sections of the website or within the firm's annual report.

2. Find the Total Debt Ratio, which measures the amount of money the firm uses from its current liabilities and long-term debt. Divide "Total Liabilities" by "Total Assets" (both found in the balance sheet) to calculate a percentage for the Total Debt Ratio. Compare the Total Debt Ratio to the Total Debt Ratio of a competing firm to see which company is more leveraged (uses more debt versus assets). More leverage (a higher ratio) usually means magnified expected earnings for the investor; however, firm managers risk complications with creditors.

3. Find the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) Coverage Ratio, which measures a firm's ability to repay debt obligations for short-term investments (less than five years). Add EBITDA to the lease payments, and then divide this amount by the sum of interest, principal payments and lease payments (all found in the income statement). Compare the ratio to a competing firm's ratio. The higher the ratio, the better able the firm is to repay its debt obligations if needed.

4. Find the Times-Interest-Earned Ratio, which measures how well the firm can meet annual interest costs in the long term. Divide Earnings Before Interest and Taxes (EBIT) by the interest (found in the income statement). Compare the ratio to a competing firm's ratio. The higher the ratio, the greater the firm's ability to conduct future financing and protect your investment.

Tips & Warnings

• If you are unsure of your abilities to locate the appropriate items to calculate these debt management ratios, consult a licensed financial adviser. Use debt management ratios with liquidity ratios and asset management ratios to get a more complete picture of the financial health of a firm.

• Don't use debt management ratios on their own to make investment decisions. Debt is only one vehicle for firms to finance their operations; on their own, the debt ratios only tell part of the story.

Resources

• Licensed financial advisors listing at U.S. SEC