When an entrepreneur opens a new business, he often starts with an idea for a product. He invests some of his own money to start producing and selling the product, eventually increases production, and then looks for stable forms of capital as the business evolves. Typically, the initial seed money is complemented by profits received from selling the product, providing liquidity to fund daily operations. Eventually, the company determines which capital structure it will use to operate long term.
This process of evolution brings us to the next set of ratios. Business risk ratios examine a company’s capital structure. Just as a short-term liquidity crunch can lead to failure, an overly risky capital structure that relies too heavily on debt can squeeze the best company.
When examining business risk we focus on four ratios: the debt-to-equity ratio, interest coverage ratio, maximum earnings decline ratio, and the financial leverage ratio. To calculate and understand each ratio, see the following:
1. Debt-to-Equity Ratio – The debt-to-equity ratio is calculated as follows:
Total Debt / Total Equity
This ratio summarizes the capital structure of a business. Companies with high debt levels will often see high returns on equity, but the risk exists that the high amount of debt could topple the firm. The ratio will vary by industry so it is difficult to establish one guideline for an acceptable debt level. Instead, watch the direction and trend of the ratio. Over time, mature companies will add more debt to the balance sheet as earnings predictability allows them to manage the fixed charge. However, this transition should be gradual. A company for which this ratio increases sharply over a short period may be having trouble finding alternate methods to finance its business.
2. Interest Coverage Ratio – The interest coverage ratio is calculated as follows:
Earnings Before Interest and Taxes (EBIT) / Interest Expense
This ratio measures the protection available to creditors as it calculates the number of times over the EBIT can cover the interest expense. Over short time horizons, this metric is more important than the debt/equity ratio. Even if a company were to carry high debt levels, the ability to service the debt and convert the interest expense offers comfort.
3. Maximum Earnings Decline Ratio – The maximum earnings decline ratio is calculated as follows:
1– (1 / Interest Coverage Ratio)
This ratio determines the amount EBIT could decline before a company will have problems paying its annual interest expense. It offers an excellent sensitivity tool that allows you to determine what a severe drop in business would do to a company’s financial position.
4. Financial Leverage Ratio – The financial leverage ratio is calculated as follows:
Total Assets / Total Equity
This ratio determines how much of a company’s assets are supported by its equity base. Many of the meltdowns in the banking sector occurred because companies had high financial leverage ratios. When the asset base is high, it only takes a minimal decline in value to eliminate the equity base and push a company toward bankruptcy.
While the net result of leverage is clear, the difference between liquidity and business risk is nuanced. Liquidity deals with debts that must be settled in less than one year, while business risk addresses those debts to be paid in more than one year. By examining the entire balance sheet, we can prevent unexpected events from having catastrophic results.
Sean Hannon, CFA, CFP is a professional fund manager.