How much debt a business has on its balance sheet? This is an important consideration when it comes to assessing financial health of a firm. Leverage ratios disclose to what an extent debt is used in a firm’s capital structure. It is believed that the more debt a firm has in its capital structure, the riskier its stock becomes. The underlying reason for this is that debtors have a priority or first claim to a firm’s assets and if ever, the firm went bankrupt, debtor’s claims must be paid off before stockholders (who are party to business risk and owners of the firm).

Debt/Equity Ratio

D/E or debt/equity ratio is an indicator of the debt financing in a business as compared to stockholder equity (finance by its owners/shareholders).

The formula for Debt/Equity Ratio

Debt/Equity Ratio = (Short-Term Debt + Long-Term Debt) / Total Equity

A high debt/equity ratio is an indicator of high risk business and a low debt/equity ratio, if other factors are similar, is deemed to mean that the business is less riskier than those with higher debt/equity ratio. However, one should not jump to the conclusion that debt is an evil and a low debt/equity ratio is an indicator of splendid financial management. Low debt/equity ratio may also indicate that a business is not using financial leverage to enhance its profitability.

How? One is prompted to ask….

Very briefly, the cost of debt is ‘fixed’ while that of equity is not – shareholders have a claim on the profits through dividends. It is also important to note that ‘fixed’ doesn’t necessarily mean high cost and that is where financial leverage comes into play – by optimizing its capital structure on debt as well as equity, a business actually ends up paying out less as a composite of dividends and interest.

Another factor that is to be remembered is that comparison of debt/equity ratios should generally be done among businesses within the same industry as higher debt/equity ratios are generally observed in capital-intensive industries.

We’ll learn about Interest Coverage in the next post.

It is imperative for a business owner to be ‘on top of things’ and constantly evaluate the performance of the business, irrespective of the size of the business – it could be a small printing business or a mammoth multi-product conglomerate. Business performance, though it may seem great in absolute terms, always has subjectivity involved and it is crucial to compare it industry competitors & established industry benchmarks. It is here that financial ratio analysis comes in handy.
The purpose of this post is to introduce the subject of financial analysis to small businesses, entrepreneurs and young managers, especially the significance of financial ratios.

What is financial ratio analysis?

Financial ratio analysis is the selection, evaluation and interpretation of financial data in easier to understand ratios, which have been identified as critical indicators of financial performance of the business and can be used for strategy and decision-making. Financial ratio analysis is popularly used to compare a firm’s financial performance over a period of time (trend analysis) or to assess performance in comparison to other businesses.

Categories of financial ratios

Financial ratios can be grouped into categories which highlight the various facets of a firm’s financial health and operational efficiency. Some of the categories of ratios are given below:

• Leverage Ratios disclose to what extent debt is used in a firm’s capital structure.
• Liquidity Ratios present a firm’s short term financial situation or solvency.
• Operational Ratios present a firm’s operational efficiency & asset utilization.
• Profitability Ratios indicate the return on sales and capital employed.
• Solvency Ratios measure a firm’s ability to generate cash flow and honor its financial obligations.

In our next post, we’ll take up Leverage Ratios in more detail.