Before issuing more debt to a company, lenders want to know how well it can meet existing interest payments. There are a few accounting ratios that management and lenders use to measure a company's ability to meet debt payments. The debt ratio compares debt with assets while the debt-to-equity ratio compares debt to equity. The debt/EBITDA ratio considers company income while the interest coverage ratio singles out the ability to make interest payments.
The debt ratio compares total liabilities and debt to company assets. The ratio provides a snapshot of how many assets are available to potentially pay down existing debt. The debt ratio equals total liabilities divided by total assets. For example, a business with $100,000 in liabilities and $250,000 in assets has a ratio of 0.4. The higher the ratio, the more liabilities and debt the company holds relative to assets. A higher ratio means it will be harder for a company to pay down debt.
Another way to measure a company's ability to pay debt is to compare debt to income. This ratio may work in the favor of a young business that doesn't have a large amount of assets but has strong annual income. The debt-to-EBITDA ratio equals debt divided by income before considering interest, taxes, depreciation and amortization expense. For example, if a company has debt of $100,000 and net income of $50,000, it has a ratio of 2. Like the debt ratio, a lower number is better and indicates the company has resources to pay off debt.
Some investors prefer the debt-to-equity ratio over the debt ratio. That's because the debt ratio considers total assets whereas the debt-to-equity ratio considers the net assets that aren't encumbered by liabilities. The debt-to-equity ratio is total liabilities divided by stockholder's equity. For example, a business with liabilities of $100,000 and equity of $150,000 has a ratio of 0.66. A lower number means there's more equity available to cover debt payments.
Interest Coverage Ratio
While a company doesn't have to make interest payments on equity financing, it must make them on debt financing. The interest coverage ratio examines a company's ability to make its interest payments. The ratio calculates how many times over a company's earnings before interest and taxes will pay for interest payments. To calculate interest coverage, divided earnings before interest and taxes by interest expense. For example, a company with earnings before interest and taxes of $60,000 and interest expense of $10,000 has a ratio of 6. That means net earnings before interest and taxes can pay for interest payments six times over.
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