Firm managers often use various financial ratios to gauge the health of the business. Comparing the ratios of the business with other firms in the same industry provides a reference point because normal ratios vary from industry to industry. Financial ratios that relate to debt allow managers to determine whether the business is using its resources appropriately.
Debt ratios indicate whether a firm has healthy levels of debt. The firm's managers can calculate these ratios by looking up the appropriate numbers from its financial statements. However, these ratios are not meaningful by themselves. Businesses need to compare the firm's performance to the firm's past performance and the performance of other firms in the same industry. The firm also needs to look at several different debt ratios to obtain a good overall look at the firm's health.
The liquidity ratios indicate whether a firm has enough assets to meet its short-term debt obligations. These include the current ratio, quick ratio, cash ratio and working capital ratio. In all cases, a high ratio indicates that the firm has plenty of assets to pay its debtors, but could also mean that the firm is not using its assets efficiently. A low ratio shows that the firm may not be able to comfortably meet its short-term debt obligations. The firm should compare its ratios with other firms in the industry to determine whether its ratios are within a healthy range.
Leverage ratios also measure whether the firm can pay its debtors, but take a long-term view. Leverage ratios include the debt-to-asset ratio, debt-to-equity ratio, times-interest-earned ratio and capitalization ratio. They indicate whether the firm can absorb losses now and still meet its future debt obligations. These ratios help the firm determine whether it can afford to take on more debts and risky projects. The healthy range of leverage ratios varies from industry to industry.
Bad debts refer to the debts that the firm can't collect from its debtors. Bad-debt ratios include the bad-debt-to-accounts-receivable ratio and bad-debt-to-sales ratio. Bad-debt ratios that are higher than the industry average indicate that the firm takes on too much risk and absorbs too much loss from unreliable debtors. Compared to other firms in the industry, the firm may have fewer resources as a result. The firm may decide to tighten its debtor criteria if its bad-debt ratios are too high.