Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation, i.e. repayment of principal and periodic interest. If the company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and allows it to exploit business opportunities and grow.
Note that total debt includes short-term debt (bank advances + the current portion of long-term debt) and long-term debt (bonds, leases, notes payable).
1. Leverage Ratios
1a. Debt to Equity Ratio = Total Debt / Total Equity
Some analysts prefer to use this ratio, which also shows the company’s reliance on external sources for financing its assets.
In general, with either of the above ratios, the lower the ratio, the more conservative (and probably safer) the company is. However, if a company is not using debt, it may be foregoing investment and growth opportunities. This is a question that can be answered only by further company and industry research.
A frequently cited rule of thumb for manufacturing and other non-financial industries is that companies not finance more than 50% of their capital through external debt.
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