Business Finance Online

Debt Management Ratios


Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid financial distress in the long run. These ratios are also known as Long-Term Solvency Ratios.

Debt is called Financial Leverage because the use of debt can improve returns to stockholders in good years and increase their losses in bad years. Debt generally represents a fixed cost of financing to a firm. Thus, if the firm can earn more on assets which are financed with debt than the cost of servicing the debt then these additional earnings will flow through to the stockholders. Moreover, our tax law favors debt as a source of financing since interest expense is tax deductible.

With the use of debt also comes the possibility of financial distress and bankruptcy.The amount of debt that a firm can utilize is dictated to a great extent by the characteristics of the firm's industry. Firms which are in industries with volatile sales and cash flows cannot utilize debt to the same extent as firms in industries with stable sales and cash flows. Thus, the optimal mix of debt for a firm involves a tradeoff between the benefits of leverage and possibility of financial distress.

Debt Ratio, Debt-Equity Ratio, and Equity Multiplier

The Debt Ratio, Debt-Equity Ratio, and Equity Multiplier are essentially three ways of looking at the same thing: the firm's use of debt to finance its assets. The Debt Ratio is calculated by dividing Total Debt by Total Assets. The Debt-Equity Ratio is calculated by dividing Total Debt by Total Owners' Equity. The Equity Multiplier is calculated by dividing Total Assets by Total Owners' Equity.

Example Problems
Use the information below to calculate the Debt Ratio, Debt-Equity Ratio,
and Equity Multiplier.
Total Assets: $
Total Debt: $
Total Owners' Equity: $
Debt Ratio: %
Debt-Equity Ratio:
Equity Multiplier:
   

 

© 2002 - 2010 by Mark A. Lane, Ph.D.