In order to analyze the debt position of your company, you need to have the company's balance sheet and income statement at your disposal. You will need information from both financial statements. The debt ratios look at the company's assets, liabilities, and stockholder's equity.

The balance sheet for this tutorial contains data accumulated over two years for a hypothetical firm. Note that ratio analysis is effective only when we can compare the ratios we calculate to data for other years or to industry averages.

In this exercise, we will review the 2007 income statement to calculate the 2007 debt ratios for the firm. Then, we'll compare those numbers to the 2008 debt ratios while explaining what any fluctuation one year to another means. You may replicate the results for your own firm.

## Calculate the Debt to Asset Ratio

*Tip: Click on the image to see it in full screen mode. You will also see it in a different window so you can read the explanation and see the image at the same time.*

The debt to assets ratio shows you how much of your asset base is financed with debt. The key thing to remember is that if 100% of your asset base is financed with debt, you're bankrupt! You want to keep your debt to asset ratio in line with your industry. You also want to watch the historical trends in your firm and your ability to cover your interest expense on debt.

Take a look at the balance sheet. All the data you need is here and is highlighted. The debt to assets ratio is: **Total Debt/Total Assets**

On the balance sheet for 2007, total assets is $3,373. In order to get total debt, you have to add together current debt (current liabilities), which is $543, and long-term debt, which is $531. The calculation becomes:

**Debt to Assets = $543 + $531/$3373 = 31.84%**

The debt to assets ratio for XYZ Corporation is 31.84% which means that 31.84% of the firm's assets are purchased with debt. As a result, 68.16% of the firm's assets are financed with equity or investor funds.

We don't know if this is good or bad as we don't have industry data to compare it with. We can calculate the ratio for 2008. If you do that, you will see that the debt to assets ratio for 2008 is 27.79%. From 2007 to 2008, the debt to assets ratio for XYZ Corporation dropped from 31.84% to 27.79%.

A drop in the debt to assets ratio may be a good thing, but we need more information to analyze this adequately.

## Calculate the Debt to Equity Ratio

A business is financed by either debt or equity (money invested by owners) or a combination of the two. The debt to equity ratio measures how much debt is used to finance the company in relation to the amount of equity used. Using debt financing is riskier for the company than using equity financing. As the proportion of debt financing goes up, the risk of the firm also goes up. That's why calculating this ratio is important, particularly to the owner's of the firm.

Take a look at the balance sheet. You can see that total debt and shareholder's equity are both highlighted. Those are the two figures that you need to calculate the debt to equity ratio. The calculation is: **Total Debt (Liabilities)/Shareholder's Equity = _____ %**

When you calculate the debt to equity ratio for 2007, you get:

**$543 + $531/$2299 = 46.72%**

This means that 46.72% of the firm's capital structure is debt and the remainder is supplied by investor capital. Like any other ratio, you need comparative data in order to know if this is good or bad. We don't have industry data but we can calculate the 2008 debt to equity ratio.

If you calculate the 2008 debt to equity ratio, the result is **38.48%**. In 2008, the firm is using less debt to finance its operations which may be good. We have to do more advanced financial analysis, however, to know that for sure.

## Calculate the Times Interest Earned Ratio (Interest Coverage)

Another debt or financial leverage ratio that is important to calculate for a company is the times interest earned ratio (TIE) or the interest coverage ratio. The TIE ratio tells the owner of the small business how well the firm can cover its interest expense on debt. If the firm uses debt financing, it has to be able to pay its interest expense.

Usually, if a firm has high debt ratios, then the times interest earned ratio is usually low since it would be more difficult to pay its interest expenses if it has a lot of debt. On the other hand, if the company's debt ratios are low, then the time interest earned ratio would be high as it would be easier to cover the company's interest expenses.

The numbers for the TIE ratio come from the company's income statement as shown above. Here is the calculation for the company's TIE ratio for 2007:

**EBIT/Interest Expense = ____ X**

**$691/$141 = 4.9 X**

This means that the company can meet its interest expenses 4.9 times over each year. We don't know if that is good or not without something to compare it to and we don't have comparative data. What we do know, however, is that XYZ Corporation can pay its interest expense at least more than one time over each year.

## Interpretation of Beginning Debt Ratio Analysis

We've calculated the three most important debt management, or financial leverage, ratios to determine XYZ Corporation's debt position. As you can see in the table above, the company is relying less on debt financing in 2008 than they were in 2007.

That is often a positive sign for a company's financial health. More debt means more risk. More debt also usually means that the company has less cash available to pay its suppliers and for general operations since it has to cover its interest expense. This company is relying more on owner financing now. For a small business, that is a positive sign.