Financial analysis indicators - financial structure and indebtedness
This series follows the series about Group of financial analysis indicators and describes in detail the indicators of financial structure and indebtedness.
Indicators of indebtedness and financial structure
The company may be financed by equity (share capital, share premium, retained earnings) and debts (loans, outstanding liabilities etc.).
Indebtedness is the term used to evaluate the extent to which is the entity financed by debts (or generally liabilities).
Indicators of indebtedness and financial structure monitor how the company is financed and what is its ability to cover long-term liabilities.
Group of indebtedness and financial structure indicators include:
- Debt ratio / Debt to assets ratio (!)
- Equity ratio / Equity to assets ratio
- Debt to equity ratio (D/E) (!)
- Equity to debt ratio
- Interest coverage / Times interest earned (TIE) (!)
- Interest burden
- Solvency
- Overcapitalization / Undercapitalization
- Debt-service coverage ratio (DSCR)
- Debt repayment period
Advantages and disadvantages of financing by equity and debt
In business world, debt financing is paradoxically cheaper than from equity, because:
- the cost of debt is interest, which is lower than the dividend (profit sharing) paid to shareholders – it is mainly due to the fact that equity holders are satisfied in case of liquidation either after debtholders or are not satisfied at all
- the effect of tax shield
- transaction costs for obtaining debt are usually lower than for equity
- possibly also the effect of financial leverage
However, high level of debt is associated with the following risks:
- lower creditworthiness - the company may not be able to meet its obligations in future or it will have problems to obtain a loan
- high cost of debt (interest), which reduces the profitability of the company and thus also the dividend to shareholders
- the risk of realization of assets held by the bank as a collateral
Equity is thus more expensive than debt capital and carries the following risks:
- it may not be sufficient enough in the future and the company may not be able to secure other sources of funding
- equity increases may bring more people with control which may threaten the flexibility in decision-making
Debt ratio / Debt to assets ratio
Debt ratio (Debt to assets ratio) is one of the indicators of indebtedness and financial structure. It expresses the ratio of debt to total assets. The higher is the indicator, the higher the level of debt and the associated risks.
It must together with indicator Equity ratio / Equity to assets ratio give 1 (100%).
Calculation formula
Instead of total liabilities can be used only payables, loans or long-term loans.
Recommended value
- very generally is recommended that the value shall be < 50%, however higher values does not necessarily indicate a problem comparison to previous periods is important
- the result is strongly dependent on the industry
Equity ratio / Equity to assets ratio
Equity ratio (Equity to assets ratio) is one of the indicators of indebtedness and financial structure. It expresses the ratio of equity to total assets. This indicator shows what proportion of assets will remain to the owners if the company pays out all the obligations. From the inverse perspective it may also help evaluate the company's indebtedness.
Together with the Debt ratio it must give 1 (100%).
Calculation formula
Recommended value
- very generally, it is recommended that the value shall be > 50%, but lower values do not necessarily indicate a problem; comparison to previous periods is important
- the result depends strongly on the industry
Debt to equity ratio (D/E)
Debt to equity ratio (D/E) is one of the indicators of indebtedness and financial structure. It expresses the proportion of debt capital to equity. The inverted indicator is Equity to debt ratio.
Calculation formula
Instead of the debt capital can be used only payables, loans and long-term loans.
Recommended value
- Recommended value should be a little below 1 (100%)
- values < 1 = low indebtedness because debt capital is lower than equity
- values > 1 = increased indebtedness because debt capital exceeds equity
- values > 1,5 = high indebtedness
However, the result is strongly dependent on the industry. Capital-intensive companies tend to have higher coefficients. (15)
Equity to debt ratio
Equity to debt ratio is one of the indicators of indebtedness and financial structure. It is inversed indicator to Debt to equity ratio (D/E), which more widely used.
Calculation formula
Interpretation and recommended values
can be derived from the text presented within Debt to equity ratio.
Interest coverage / Times Interest Earned - TIE
Interest coverage (Times Interest Earned - TIE) is one of the indicators of indebtedness and financial structure. It shows how many times the earnings before interest and taxes (EBIT) are higher than interest expense, or how many times can the earnings be reduced before it reaches the border of interest expense. The higher is thus the indicator, the better.
If the indicator is high, high ability to repay loans and take out a new loan can be expected.
Inverse indicator is Interest burden.
Calculation formula
The formula can include the total cost of borrowings instead of interest expense.
Recommended value
- value should definitely be > 3, but ideally > 7
- value < 1 means that the company is not even at present able to pay interest from its profit
Interest burden
Interest burden is one of the indicators of indebtedness and financial structure and it shows what proportion of earnings before interest and taxes (EBIT) are used to cover interest expense.
It is inversed indicator to Interest coverage, which is much more widely used in practice.
Calculation formula
The formula can include the total cost of borrowings instead of interest expense.
Interpretations and recommended values
can be derived from the text presented within Interest coverage ratio.
The indicator of overcapitalization / undercapitalization
The indicator of overcapitalization / undercapitalization is one of the indicators of indebtedness and financial structure and possibly also liquidity.
The ratio indicates the proportion in which are fixed assets financed by long-term funds. The analysis provides similar result as the analysis of working capital.
Calculation formula
Interpretation
- if > = 1 overcapitalization, i.e. the company covers by long-term funds also current assets
→ lower risk (serves as a buffer, because it is possible to use the money raised from the potential sale of current assets financed by long-term sources for something else without compromising the stability of the entity)
→ lower efficiency, because long-term funds tend to be more expensive than short-term funds
- if <1 = undercapitalization, i.e. the company covers a part of its fixed assets by short-term funds
→ risk that the entity will be forced to sell this part of fixed assets to be able to pay its short-term liabilities
The indicator should surely be greater than 1. However, there is no generally recommended value; it depends on specific conditions.
Debt-service coverage ratio (DSCR)
Debt-service coverage ratio (DSCR) is one of the indicators of indebtedness and financial structure. It shows the proportion of cash-flow (calculated simply from profit after tax) for the reporting period on all future installments of loans, including interest payments.
Calculation formula
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EAT/PAT - Earnings/Profit After Tax
Interpretation
The higher the value, the better.
Debt repayment period
Debt repayment period is one of the indicators of indebtedness and financial structure. It shows in years, how long it is expected that the company will repay its loans and borrowings from operating cash flow.
This indicator is an inverted indicator of Solvency.
Calculation formula
Instead of operating cash flow may also be used total cash flow or profit.
Interpretation
The lower is the indicator, the better. The ideal values are about 3-5 years.