Debt Ratios

Debt ratios show how a company's operations are financed. To much equity often means that management is not taking advantage of the leverage associated with long term-term debt. Financial leverage, a term used to describe the magnification of risk and return introduced through the use of fixed-cost financing such as debt and preferred stock.

There are two general types of debt measures: measures of the degree of indebtedness and measures of the to ability debts.

The degree of indebtedness measures the amount of debt against other significant balance sheet amounts. Two of the most commonly used measure are the debt ratio and the debt-equity ratio.

The ability to meet certain fixed charges is measured using coverage ratios: times interest earned and the fixed-payment coverage ratio.

Debt Ratio

The debt ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its total assets:

Debt ratio = Total liabilities
Total assets

The debt ratio for Jimco in 1993 is:

$10,000,000 + $10,700,000 = .668, or 66.8%
$31,000,000

industry average = 54.9%

The higher this ratio, the more financial leverage a firm has.


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Finance For Strategic Management
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