Financial risk ratios and its importance
Financial risk is the type of risk primarily associated with the risk of default on the loan taken by any entity. To evaluate any company’s capital structure and debt levels, as a part of quantitative analysis, financial risk ratios are used. The most commonly used types of financial risk ratios are Leverage ratio, Interest Coverage ratio and Debt Service Coverage ratio.
Leverage ratio – It is commonly known as debt-to-equity ratio. This ratio signifies how much debt does the firm employs in relation to its use of equity. This is an important ratio as it provides company’s ability to pay off debt using its own capital.
Leverage Ratio Formula = Total Debt (current + long term) / Shareholder’s Equity
A lower ratio is generally considered better as it shows greater asset coverage of liabilities with own capital. Capital intensive sectors generally show a higher debt to equity ratio as compared to services sector. If the leverage ratio is increasing over time, then it may be concluded that the firm is unable to generate sufficient cash flows from its core operations and is relying on external debt to stay afloat.
Interest Coverage ratio - This ratio signifies the ability of the firm to pay interest on the debt.
Interest Coverage Formula = EBITDA / Interest Expense
Capital intensive firms have higher depreciation and amortization resulting in lower operating profit. In such cases, EBITDA is one of the most important measures as it is the amount available to payoff interest. Higher interest coverage ratio implies greater ability of the firm to pay off its interests. If interest coverage is less than 1, then EBITDA is not sufficient to pay off interest, which implies finding other ways to arrange funds.
Debt Service Coverage ratio – This ratio signifies whether the operating income is sufficient to pay off all obligations that are related to debt in a year. It also includes committed lease payments. Debt servicing consists of not only the interest, but also some principal portion also is repaid annually.
Debt Service Coverage Formula = Operating Income / Debt Service
Where, Operating Income = EBIT and Debt Service = Principal Payments + Interest Payments + Lease Payments
Debt Service Coverage ratio of less than 1 implies that the operating cash flows are not sufficient enough for Debt Servicing implying negative cash flows. This is pretty useful matrix from Bank’s point of view, especially when it gives loans against property to individuals.
These ratios help investors to analyse the debt proportion of the companies and assess its ability to pay it off. Analysing debt structure is one of the important parameters to be considered while making investment decisions. High debt may generate chances of default. The purpose towards which debt is utilised should also be considered.