How is the firm financing its assets?

How the Company is financed? do the management finance the assets more by debt or equity? can the company meet debt services? In answering this question, we will use the below ratios.


Debt/equity ratio: this ratio is computed as follow

                  Debt/equity ratio = Total liabilities ÷ Total Equity

The high percentage means that the company less depends on leverage, less risk can be considered and stronger its equity position. But less percentage means Company uses more debts than equity to finance its assets, and the more Leverage Company uses can be double-edged sword for the company, first to generate returns above its cost of capital to be on the investor’s benefits and second it can hurt the company if the generated returns cannot exceed the cost of capital. Also, the less ratio is not necessary good or bad indicators, the ratio should be compared to peers in the same industry and will put the company at real risk in the market if the company engaged in debts when interest rates is on rise and then the economy goes into a recession.

 

Long-term debts ratio: this ratio is computed as follow:

Long-term debts (LD) ratio = LD ÷ (LD + total equity)

A low level of debt and good proportion of long-term debt to capital structure is an indication of financial fitness Increases in debts reflect the availability of financial resources to a company for growth and expansion.

There is no fixed optimum amount of debt. Leverage varies according to industries and Company’s stage of development.

 

Interest coverage ratio: This ratio is used to determine the ability of a company to pay interest expenses on outstanding debt which can be considered as margin of safety of paying debt expenses and it is computed as follow

            Interest coverage ratio = EBIT ÷ Interest expenses

The lower the ratio, the less ability of the company to pay debt expense and may expose the company to going concern risk. Interest expenses affect a company's profitability, therefore, the management should determine cost-benefit of financing its assets, development or expansion by debts. The minimum required ratio for investors is not less than 1.5.

 

Cash Flow-To-Debt ratio: this ratio provides an indication of a company's ability to cover its debt with its cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt and more ability to pay debt services by the cash generated from normal course of business not by proceeds of selling its assets or from its equity (retained earnings, increasing its stocks that may lead to decrease the stock price in the market)

Cash Flow-To-Debt ratio = Operating cash flow ÷ Total debt

There is a conservative approach for computing cash flow figure that deduct the amount of cash used for capital expenditures from operating cash flow. The higher ratio, the better indicator is.

Any low ratios that are mentioned above should be investigated on their major factors behind those law ratios. Company should compare its current ratios to its historical level in order to know trends or warning signs.