Learning Resource

Financial Statement Analysis: Ratios that Analyze a Company's Long-Term Debt-Paying Ability

Creditors interested to know if a company can pay its long-term debts use several ratios to determine the answer.

Debt Ratio

The debt ratio measures how much a company owes in total liabilities for every dollar in total assets it has. This is a good overall ratio for telling creditors or investors if they have enough assets to cover their debt. The formula for calculating this ratio is as follows:

\[\frac{\text{total assets}}{\text{total liabilities}}\] 
\[\frac{\text{total assets}}{\text{total liabilities}}=\frac{\$7,041}{\$9,481.80}\] 

The total assets of Synotech are $7,041 and total liabilities are $9,481.80. To calculate Synotech's debt ratio we divide total liabilities by total assets and arrive at 74.3%.

Times Interest Earned or Interest Coverage Ratio 

Long-term creditors use the times interest earned ratio (or interest coverage ratio) to learn whether a borrower can meet required interest payments when the payments come due. It is computed as follows:

\[\frac{\mathrm{income}\;\mathrm{before}\;\mathrm{interest}\;\mathrm{and}\;\mathrm{taxes}\;(\mathrm{IBIT})}{\mathrm{interest}\;\mathrm{expense}}\] 

This ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense. Income before interest and taxes (IBIT) is the numerator because there would be no income taxes if interest expense were equal to or greater than IBIT. (To find income before interest and taxes, take net income from continuing operations and add back the net interest expense and taxes.) Analysts disagree on whether the denominator should be (1) only interest expense on long-term debt, (2) total interest expense, or (3) net interest expense.

We will use net interest expense in our example. For Synotech, the net interest expense is $236.9 million. With an IBIT of $1,382.4 million, the times interest earned ratio is 5.84. The company earned enough during the period to pay its interest expense almost 6 times over.

Low or negative interest coverage ratios suggest that the borrower could default on required interest payments. A company is not likely to continue interest payments over many periods if it fails to earn enough income to cover them. On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to default on interest payments.

Licenses and Attributions

Ratios That Analyze a Company’s Long-term Debt Paying Ability from Financial Accounting by Principles of Accounting I, Lumen Learning is available under a Creative Commons Attribution 4.0 International license. © 2015, Lumen Learning. UMGC has modified this work and it is available under the original license.