Financial ratios are short formulas that help us understand the economic condition of a company. You can use ratios to help select in which of two similar companies to buy stock. The ratios give you important knowledge, like the efficiency of sales and operations, returns on investments and the effective use of debt to increase income. Debt-equity ratio and total debt ratio are statistics that reveal information about efficiency and risk.
A company’s balance sheet lays out a snapshot of a company's economic conditions in an organized, standardized format. On the left is the asset section, composed of current assets like cash and long-term assets such as factories. In the middle is the liabilities section for short-term (under 1 year) and long-term (over 1 year) debt. The last balance sheet section, shareholders' equity, describes the ownership stake of the stockholders. It's composed of a set of accounts, called paid-in capital, that lists all the stock issued, and another account called retained earnings, which shows all of the accumulated, unspent profits of the company. Income increases retained earnings, expenses reduce it. Dividends are paid from retained earnings. The accounting equation states that assets equal liabilities plus stockholders equity. This equation must balance to the penny – that’s why it’s called the “balance sheet."
Leverage has several meanings. In this context, it refers to the ability to increase earnings through debt. “Earnings per share” is a very important ratio used to help set a value for a stock’s price. Both debt and equity can be used to provide operating cash to a company and thus allow the company to earn a profit. When debt is used instead of shares to increase company earnings, new shares need not be issued, and thus the earnings per share ratio climbs. But a company cannot issue too much debt -- the interest charges will mount up, drain cash and threaten the company with default. A company that can't meet its bond payment obligations will be forced into bankruptcy.
"Capital structure" is a term used to describe a firm's long-term debt and equity -- these are the two sources of investor money used to pay for projects and operations. Debt must be paid back, with interest. Equity includes the common and preferred stock issued by the company. The D/E ratio is the long-term debt of the firm divided by its equity. As such, it indicates the relative contributions of debt and equity to the firm’s capital structure. High D/E ratios indicate an aggressive financial commitment to growing a company without diluting the ownership of shareholders. As the cost of debt mounts, so does the possibility of insolvency – the inability to promptly pay debts. Reorganization, sale of assets, bankruptcy or liquidation may follow shortly thereafter.
Total Debt Ratio
The debt ratio is equal is to total liabilities divided by total assets. The ratio indicates the proportion of assets that are financed through liabilities. A ratio above 0.5 indicates that most of the firm’s assets are financed with debt. The pros and cons of leverage apply here as well: If the debt ratio is too high, the earnings-per-share gains are offset by the high interest costs that saddle the company. If a company uses too much debt to raise cash for operating the company, it will eventually have to reduce the amount of debt or go bankrupt. One reason why high interest rates slow an economy is that companies must lower their debt ratios, since they can no longer afford the high interest charges. If new shares are issued to pay down debt, then earnings per share will be diluted and fall.
- Ratios Made Simple: A Beginner's Guide to the Key Financial Ratios; Robert Leach
- Key Management Ratios (4th Edition); Ciaran Walsh
- Analysis of Financial Statements; Pamela Peterson Drake; Frank J. Fabozzi CFA
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.