C. Debt Ratios
1. Debt to Equity Ratio
Debt To Equity (DER) ratio measures the comparison between a Company’s Total Debt compared to its Equity.
The debt to equity ratio is as follows:
From the Balance Sheet “danieel.id Company”, we can calculate the company’s DER in 2019 is $ 3,455 / $ 7,570 = 45.6%
Debt to equity ratio measures the level of debt use by a company compared to its own capital (shareholders’ equity).
It also shows the company’s ability to cover all its debts with shareholders’ equity, if at any time the company goes into bankruptcy.
Debt to equity ratio is important for evaluating a company’s financial leverage (financial leveraging is the use of debt to acquire additional assets). The larger this ratio indicates the greater the Company is using other people’s money (debt) to make a profit.
Of course, the greater the debt means the greater the risk borne by the Company (if then for example the profit generated from the debt is less than the cost of its debt (interest).
But behind the great risk also contained a large potential return as well (as we often hear in the business world “high risk high return”).
Of course there are optimum and maximum numbers of this ratio. Ratio 1 is often viewed as the optimum ratio where it means liabilities = equity.
For maximum ratios vary depending on the type and size of the Company, for most companies the maximum ratio is 1.5 – 2.
For creditors/ lenders, debt to equity is an important ratio for evaluation, whether the company can be considered for additional debt.
For investors, the debt to equity of a company that is too large (or an increasing trend compared to the previous year) indicates increased risk.
Conversely, debt to equity that is too low can mean that the company has not used its financial leverage optimally to increase profits.
2. Times Interest Earned Ratio (Interest Coverage Ratio)
Times Interest Earned Ratio or often called Interest Coverage Ratio is a ratio that measures a company’s ability to pay interest costs from its loans.
The Formula Times Interest Earned Ratio is as follows:
From the Income Statement “danieel.id Company”, we can calculate the Times Interest Earned Ratio of this company in 2019 is : $ 935 / $ 199 = 4.7
The greater this ratio means the better the Company’s ability to pay its interest obligations, and vice versa.
This ratio is very important for creditors or lenders in assessing the feasibility of a Company getting additional debt.
In extreme situations, where the ratio is too small (e.g. 1), the Company is caught up in a situation called a “Zombie Company”, where the Company generates only enough profit to pay interest on its debts.
(or if the ratio is below 1, it means that the profit generated is even less than the interest costs that the Company has to bear).
3. Fixed Payment Coverage Ratio
Fixed Payment Coverage Ratio is a ratio that measures a Company’s ability to pay all of its fixed obligations, such as interest expenses, including principal, rental costs, and preferred stock dividends.
The Fixed Payment Coverage Ratio formula is as follows:
Note:Â T is a corporate income tax that applies to the company.
The term [1/(1-T)] is used to readjust the principal’s after-tax value and preferred stock dividend to its before-tax value to be consistent with other parameters in this formula.
From the financial statements “danieel.di Company), we can calculate the Fixed Payment Coverage Ratio is: ($935 + $68) / {($199 + $68) + (($36 + $30) x [1/1-0.25])} = 2.83
This ratio of 2.83 indicates that the Company’s profits are almost three times greater than the amount of its fixed liability obligations. This number is safe and more than enough.
Like the Interest Coverage Ratio, the greater this ratio means the smaller the risk for both lenders and owners, and vice versa.
Summary Debt Ratios
From the table above we can see, in the case “danieel.id Company”:
Debt to Equity ratio of this company in 2019 increased compared to 2018, this figure is also slightly higher than the average Debt to Equity ratio of similar industries.
As we discussed earlier above, if viewed from a risk point of view, this can be less good, in the sense that the Company’s risk in bearing the burden of debt increases.
However, if viewed from the point of view of financial leverage and potential growth, this means that the Company is increasing its investment, which comes in part from additional debt, in hopes of increasing returns in the future (with a note if the investment is right and the business is growing properly of course).
And as we also discussed in the previous article (Understanding the 4 Types of Company Financial Statements), if we look at the Balance Sheet and Cash Flow Statement (Statement of Cashflow) “danieel.id Company” in 2019, we can see that companies make investments mainly by buying new machine machines (can be seen from the increase in gross fixed assets on the balance sheet).
Investors looking for growth opportunities for a company usually see this as a good indication that the Company is trying to grow.
For the Interest Coverage Ratio, the “danieel.id Company” number decreased slightly compared to the previous year (4.70 in 2019, compared to 4.75 in 2018), but this ratio is still better than the average of similar industries in 2019 (4.3).
For the Fixed Payment Coverage Ratio, the Company’s Performance increased, from 2.79 in 2018 to 2.83 in 2019. This figure is much better than the average of similar industries in the same year.
Overall, Debt Ratios The company is still good, and there is still space to optimize its financial leverage in an effort to pursue growth.
Next let’s discuss Profitability Ratios on page 4
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