Financial ratios can be used to assess a company's capital structure and current risk levels, often in terms of a company's debt level and risk of default or bankruptcy. These ratios are used by investors when they are considering investing in a company. Whether a firm can manage its outstanding debt is critical to the company's financial soundness and operating ability. Debt levels and debt management also significantly impact a company's profitability, since funds required to service debt reduce the net profit margin and cannot be invested in growth.
Some of the financial ratios commonly used by investors and analysts to assess a company's financial risk level and overall financial health include the debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the degree of combined leverage (DCL).
Key Takeaways
- Risk ratios consider a company's financial health and are used to help guide investment decisions.
- If a company uses revenues to repay debt, those funds cannot be invested elsewhere within the company to promote growth, making it a higher risk.
- The most common ratios used by investors to measure a company's level of risk are the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio.
Debt-to-Capital Ratio
The debt-to-capital ratio is a measure of leverage that provides a basic picture of a company's financial structure in terms of how it is capitalizing its operations. The debt-to-capital ratio is an indicator of a firm's financial soundness. This ratio is simply a comparison of a company's total short-term debt and long-term debt obligations with its total capital provided by both shareholders' equity and debt financing.
Debt/Capital = Debt / (Debt + Shareholders' Equity)
Lower debt-to-capital ratios are preferred as they indicatea higher proportion of equity financing to debt financing.
Debt-to-Equity Ratio
The debt-to-equity ratio (D/E) is a key financial ratio that provides a more direct comparison of debt financing to equity financing. This ratio is also an indicator of a company's ability to meet outstanding debt obligations.
Debt/Equity = Debt / Shareholders' Equity
Again, a lower ratio value is preferred as this indicates the company is financing operations through its own resources rather than taking on debt. Companies with stronger equity positions are typically better equipped to weather temporary downturns in revenue or unexpected needs for additional capital investment. Higher D/E ratios may negatively impact a company's ability to secure additional financing when needed.
A higher debt-to-equity (D/E) ratio may make it harder for a company to obtain financing in the future.
Interest Coverage Ratio
The interest coverage ratio is a basic measure of a company's ability to handle its short-term financing costs. The ratio value reveals the number of times that a company can make the required annual interest payments on its outstanding debt with its current earnings before interest and taxes (EBIT). A relatively lower coverage ratio indicates a greater debt service burden on the company and a correspondingly higher risk of default or financial insolvency.
Interest Coverage = EBIT / Interest Expense
A lower ratio value means a lesser amount of earnings available to make financing payments, and it also means the company is less able to handle any increase in interest rates. Generally, an interest coverage ratio of 1.5 or lower is considered indicative of potential financial problems related to debt service. However, an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.
Investors consider that a company with an interest coverage ratio of 1.5 or lower is likely to face potential financial problems related to debt service.
Degree of Combined Leverage
The degree of combined leverage (DCL) provides a more complete assessment of a company's total risk by factoring in both operating leverage and financial leverage. This leverage ratio estimates the combined effect of both business risk and financial risk on the company's earnings per share (EPS), given a particular increase or decrease in sales. Calculating this ratio can help management identify the best possible levels and combination of financial and operational leverage for the firm.
DCL = % Change EPS / % Change Sales
A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage because high leverage means more fixed costs to the firm.
The Bottom Line
Financial ratios are used in fundamental analysis to help value companies and estimate their share prices. Certain financial ratios can also be used to evaluate a firm's level of risk, especially as it relates to servicing debts and other obligations over the short and long run.
This analysis is used by bankers to grant additional loans and by private equity investors to decide investments in companies and use leverage to pay back debt on their investments or augment their return on investments.
FAQs
The most common ratios used by investors to measure a company's level of risk are the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio.
Which of these ratios measures financial risk? ›
The financial leverage ratio is used to measure overall financial risk. By measuring the amount of debt held by your company against its income, you can glean a picture of how investors see your business in terms of financial risk.
What are the 5 financial ratios used to determine? ›
5 Essential Financial Ratios for Every Business. The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.
What are the measures of risk in financial analysis? ›
The five measures include alpha, beta, R-squared, standard deviation, and the Sharpe ratio. Risk measures can be used individually or together to perform a risk assessment. When comparing two potential investments, it is wise to compare similar ones to determine which investment holds the most risk.
Is the debt ratio a measure of financial risk? ›
The debt ratio is valuable for evaluating a company's financial structure and risk profile. If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt.
What are the financial ratios used to assess risk? ›
Some of the financial ratios commonly used by investors and analysts to assess a company's financial risk level and overall financial health include the debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the degree of combined leverage (DCL).
What is the measure of risk ratio? ›
Risk ratios. When risks are computed in a study, the risk ratio is the measure that compares the Riskexposed to the Riskunexposed . The risk ratio is defined as the risk in the exposed cohort (the index group) divided by the risk in the unexposed cohort (the reference group).
What are four 4 fundamental financial ratios? ›
Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE). Most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company's financial health.
What is the most important financial ratio? ›
Return on equity ratio
This is one of the most important financial ratios for calculating profit, looking at a company's net earnings minus dividends and dividing this figure by shareholders equity. The result tells you about a company's overall profitability, and can also be referred to as return on net worth.
What is used to measure risk? ›
Some common measurements of risk include standard deviation, Sharpe ratio, beta, value at risk (VaR), conditional value at risk (CVaR), and R-squared.
5 Ways To Measure Risk
- Alpha. Alpha is a measure of investment performance that factors in the risk associated with the specific security or portfolio, rather than the overall market (or correlated benchmark). ...
- Beta. ...
- R-squared. ...
- Sharpe ratio. ...
- Standard deviation.
Standard deviation is the most common measure of risk used in the financial industry. Standard deviation measures the variability of returns for a given asset or investment approach.
What ratios primarily measure risk? ›
Some of the financial ratios that are most commonly used by the investors and analysis to access a company's financial risk level and overall financial health are debt-to-capital ratio, interest coverage ratio, activity ratio, and profitability ratios.
What is financial risk measured with? ›
Standard Deviation is one of the most common ways of measuring risk in finance. It is a method where the deviation of data in comparison to the mean value of the entire dataset is measured. The first step in calculating Standard Deviation is calculating the dataset's mean or average value.
What financial ratios are used to measure credit risk? ›
Credit Analysis Ratios: Financial Due Diligence
| Credit Metrics | Formula |
|---|
| Total Leverage Ratio | Total Debt ÷ EBITDA |
| Net Debt Leverage Ratio | Net Debt ÷ EBITDA |
| Senior Debt Leverage Ratio | Senior Debt ÷ EBITDA |
| EBIT Coverage Ratio | EBIT ÷ Interest Expense |
8 more rowsDec 28, 2023
Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE). Most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company's financial health.
Which types of ratios are commonly used to measure the financial health? ›
Common ratios used to measure financial health
- Gross profit margin.
- Net profit margin.
- Retrun or assets.
- Return on equity.
A solvency ratio measures how well a company's cash flow can cover its long-term debt. Solvency ratios are a key metric for assessing the financial health of a company and can be used to determine the likelihood that a company will default on its debt.
