# How to Measure the Debt Paying Ability in Accounting

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Before issuing more debt to a company, lenders want to know how well it can meet existing interest payments. There are a few accounting ratios that management and lenders use to measure a company's ability to meet debt payments. The debt ratio compares debt with assets while the debt-to-equity ratio compares debt to equity. The debt/EBITDA ratio considers company income while the interest coverage ratio singles out the ability to make interest payments.

## Debt Ratio

The debt ratio compares total liabilities and debt to company assets. The ratio provides a snapshot of how many assets are available to potentially pay down existing debt. The debt ratio equals total liabilities divided by total assets. For example, a business with \$100,000 in liabilities and \$250,000 in assets has a ratio of 0.4. The higher the ratio, the more liabilities and debt the company holds relative to assets. A higher ratio means it will be harder for a company to pay down debt.

## Debt-to-EBITDA Ratio

Another way to measure a company's ability to pay debt is to compare debt to income. This ratio may work in the favor of a young business that doesn't have a large amount of assets but has strong annual income. The debt-to-EBITDA ratio equals debt divided by income before considering interest, taxes, depreciation and amortization expense. For example, if a company has debt of \$100,000 and net income of \$50,000, it has a ratio of 2. Like the debt ratio, a lower number is better and indicates the company has resources to pay off debt.

## Debt-to-Equity Ratio

Some investors prefer the debt-to-equity ratio over the debt ratio. That's because the debt ratio considers total assets whereas the debt-to-equity ratio considers the net assets that aren't encumbered by liabilities. The debt-to-equity ratio is total liabilities divided by stockholder's equity. For example, a business with liabilities of \$100,000 and equity of \$150,000 has a ratio of 0.66. A lower number means there's more equity available to cover debt payments.

## Interest Coverage Ratio

While a company doesn't have to make interest payments on equity financing, it must make them on debt financing. The interest coverage ratio examines a company's ability to make its interest payments. The ratio calculates how many times over a company's earnings before interest and taxes will pay for interest payments. To calculate interest coverage, divided earnings before interest and taxes by interest expense. For example, a company with earnings before interest and taxes of \$60,000 and interest expense of \$10,000 has a ratio of 6. That means net earnings before interest and taxes can pay for interest payments six times over.

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