Debt management ratio is a financial ratio which indicates the level of debt financing in an organization. Naturally an organization may not always have all the funds it needs to operate. So what it does is borrow from lenders for short term and fulfill its obligations. After this, it generates profit from business and pays to these lenders in time. It is crucial to manage the level of debt financing because too much debt leads to too much interest payment. So it affects profitability. To mitigate this, a company makes a policy of borrowing only to certain percentage. Further, it also calculates several ratios to understand the situation of debt financing and decide accordingly. These ratios are as follows:
- 1. Debt Ratio: Debt ratio signifies the share of total debt in total assets. If the share is very high, then it can be trouble for a company because it leads to too much interest payment. Thus, the profit of company will shrink. Also, in such case creditors may not lend further. Therefore it creates trouble for the operation in a company.
Mathematically,
Debt ratio= Total Debt/ Total Assets
Naturally debt ratio shows the parts total debt comprises in total assets. So it gives an early warning to managers to stop financing by debt. Also it gives prior warning to investors to stop lending because a company may not be able to pay.
Example of Calculation
What is the debt ratio of a company with 100 million in total debt and 200 million total assets.
Solution;
Total Debt = 100 Million
Total Assets= 200 Million
Debt ratio= Total Debt/ Total Assets= 100 Million/200 Million = 1/2= 0.5
This ratio can be compared to company standards to determine whether the ratio is higher or not.
2. Debt- Equity Ratio: Debt equity ratio is the ratio of total debt to total equity. In calculating this, it shows the share of total debt in total equity. We add long term debt and current liabilities to determine the value of total debt. Whereas, total equity includes equity capital, preference share capital and undistributed profits. So debt-equity ratio shows the long term solvency position of a company.
The higher the debt equity ratio, the higher a company is debt financed. As explained in earlier topic, in such case an organization has to pay more interest and so its profits becomes low. If an organization takes huge loan, a very big amount needs to be paid as interest. Thus this situation should be avoided.
It is generally safer for an organization to increase shareholders equity. This is because they don’t have to pay interest on it and also it don’t affect profitability.
Mathematically,
Debt-Equity Ratio= Total Debt / Total Equity
For eg: Calculate the debt-equity ratio of a company having total debt 5 million and total equity of 20 million.
Solution;
Total debt= 5 million
Total Equity = 20 million
Debt-Equity ratio = 5 million/20 million = 0.25
This value should be compared to industry standards to determine if the ratio is higher or not.
3. Long Term Debt to Total Assets Ratio: This is another measure of the solvency position of a company. It is calculated by dividing long term debt with total assets. It also indicates the leverage position of a company, but in case of long term debt and not in case of total debt.
Mathematically,
Long Term Debt to Total Assets Ratio= Long Term Debt/ Total Assets
For example: Calculate the long term debt to total assets ratio if the long term debt is 300 million and total assets is 400 million.
Solution,
Long term debt= 300 Million
Total Assets= 400 Million
Long term debt to total assets ratio = Long term debt / Total Assets= 300 Million/ 400 Million = 0.75
4. Equity Multiplier: Equity multiplier is calculated as the ratio of Total Assets to Total Equity. So it shows how much times total assets is greater than total equity.
Mathematically,
Equity Multiplier= Total Assets/Total Equity
It can also be used to calculate debt ratio.
Debt ratio= 1-1/Equity multiplier
Thus if the equity multiplier is high, the debt ratio is higher. And if the equity multiplier is lower, the debt financing is lower.
It becomes necessary to calculate equity multiplier because it shows how much percentage of total assets is financed by total equity.
For Example: Calculate the equity multiplier if the Total Assets is 250 million and Total equity is 150 million.
Solution,
Total Assets = 250 million
Total Equity= 150 million
Equity Multiplier= 250 million/ 150 million= 1.66
It shows total assets is 1.66 times total equity.
5. Times Interest Earned Ratio:. As discussed earlier, a company manages its fund through debt financing and equity financing. It is crucial for a company to pay its annual interests because it creates credibility among lenders. Thus, times interest earned ratio is calculated to understand the ability of a company to pay its interest obligations. In this case, higher ratio indicates that a firm can pay its annual interest easily whereas lower ratio shows it will be difficult for a firm to pay its annual interest payment.
Mathematically,
TIE ratio = EBIT/ Interest Charges
For example: Calculate the TIE ratio if a company has EBIT of 100 million and Interest charges of 25 million.
Solution,
EBIT= 100 Million
Interest charges= 25 million
TIE ratio = 100 Million/ 25 Million = 4 times.
6. Cash Coverage Ratio: It is the ratio of cash available in the firm to pay its borrowers to total interest charges. To calculate total cash available, we sum earning before interest and taxes with depreciation. This is because EBIT show the amount of cash available before payment of interest and taxes. Also depreciation is a provision and its cash amount is hold in a company. Thus they are cash reserves.
Higher ratio show that a company can easily fulfill its interest payment obligations and lower ratio shows a company will face difficulty to pay its interest obligations.
Mathematically,
Cash coverage ratio = EBIT+ Depreciation/ Interest charges
For example: Calculate the cash coverage ratio if EBIT is 50 Million and depreciation is 1 Million. Further the interest charges is 20 million.
Solution,
EBIT= 50 Million
Depreciation = 1 Million
Interest Charges= 20 Million
Cash Coverage ratio = EBIT+ Depreciation/ Interest Charges = 50 mil + 1 mil/ 20 mil= 51/20 = 2.55
7. Fixed Charge Coverage Ratio : An organization leases its unused assets to other companies for earning. Further they also take assets on lease from other companies. Also they have sinking fund payment associated with debt. Sinking funds are the funds that are accumulated on regular intervals for payment obligations which may arise in the future.
Mathematically:
Fixed Charge Coverage Ratio = EBIT+ Lease Payments
Interest Charge+ Lease Payments+ (Sinking fund payments/ 1- tax rate)
The higher the ratio, the better the capacity of an organization to pay its fixed charges. The lower the ratio, the difficult it is for a company to pay its fixed charges.
For Example: Calculate the Fixed charge coverage ratio of a company with EBIT 50 million, lease payments of 2 million, sinking fund payments of 0.5 million and tax rate off 30 percent.
Solution,
EBIT= 50 Million
Lease Payment= 2 million
Interest charge= 10 million
Sinking funds payment = 0.5 Million
Tax rate= 30 Percent
Fixed charge coverage ratio= (50+2)/(10+2+(0.5/1-0.3))= 52/(12+0.71) = 4.09 times
8. EBITDA Coverage Ratio: It is the ratio of sum of EBITDA and lease payments divided by the sum of Interest, Principal Payments and Lease Payments. Generally this ratio is developed by Bankers to minimize the deficiencies of TIE ratio. While calculating this ratio, increasing ratio is considered favorable which shows the companies capability to pay the fixed charges.
Mathematically,
EBITDA coverage ratio= (EBITDA+Lease Payments)
( Interest+Principal Payments+ Lease Payments).
For eg: Calculate the EBITDA coverage ratio if EBITDA is 50 million, Lease payments of 5 million, Interest of 2 million and principal payments of 1 million.
Solution,
EBITDA= 50 million
Lease Payments= 5 Million
Interest= 2 Million
Principal payments= 1 million
EBITDA= (50+5)/(2+1+5)=55/8= 6.875 times
Further Reads
https://usefulfinanceforus.blogspot.com/2025/07/assets-management-ratio.html
https://usefulfinanceforus.blogspot.com/2025/07/profitability-ratios.html
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