By Ee Hsin Kok. Edited by Arjun Chandrasekar.
When evaluating a company’s financial strength, one of the most important factors is how much debt a company has taken on. However, you can’t evaluate a company based on the absolute value of its debt, as larger companies with higher earnings and/or more assets can afford to comfortably take on more debt. That’s where the use of debt ratios comes in. In this article, we’ll be covering three debt ratios you can use.
The Current Ratio
The current ratio is derived by taking the current assets of the company and dividing them by the current liabilities.
Current Ratio = Current AssetsCurrent Liabilities
This ratio is useful in assessing a company’s ability to pay off its short-term debts. In general, a ratio above 1 is a positive sign, while a ratio below 1 is a negative sign. Do note, however, that this standard of above and below 1 is not absolute. For some industries, it is very common for companies to have current ratios below 1. In that case, one should look at how the individual company stacks up against the industry standard.
The Debt to Equity (D/E) Ratio
The debt to equity ratio is derived by taking the total liabilities of a company divided by the total shareholder equity. This can only be calculated for companies where shareholder equity is positive.
Debt To Equity Ratio = Total LiabilitiesShareholder’s Equity
This ratio is useful to assess how leveraged a company is compared to its assets. A high number indicates higher leverage and therefore higher risk, while a low number does the opposite. A good debt-to-equity ratio should be below 1.5, but much like the current ratio, this varies depending on the industry standard. Additionally, a higher D/E ratio can be acceptable if the company has a low debt to EBITDA ratio, which we cover next.
The Debt to EBITDA Ratio
The debt to EBITDA ratio is derived by taking the total liabilities of a company divided by the company’s trailing twelve-month EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
Debt To EBITDA Ratio = Total LiabilitiesEBITDA (TTM)
This ratio tells us how long it will take a company to pay off all its debt. For example, a Debt to EBITDA ratio of 1.5 means that the company can pay off all its debt in just 1.5 years solely from the income it generates. Generally, it is safe to stick with companies with a Debt To EBITDA ratio of less than 3, meaning the company can use its operating income to pay off all its debt in 3 years or under, but once again this varies from industry to industry. For example, newer startup companies might have low, or even negative earnings, leading to a high Debt To EBITDA ratio. This may not be an issue if you are confident in the company’s potential to grow its earnings, but you should therefore look for good current and debt to equity ratios to compensate for the weaker Debt to EBITDA ratio.
In this article, we discussed 3 debt ratios that you can use to analyze the debt structure and financial stability of companies you may plan to invest in. No single ratio is perfect, but a combination of the 3 can give you a good idea on how conservative or risky an investment into a given company might be.