Financial statement ratio - solvency ratios (coverage)

Question 1

Solvency ratios (coverage)

Answer 1

Measure of a firm’s ability to repay its debt obligations:

• Debt to EBITDA
• Interest coverage ratio
• Fixed charge coverage
• Debt to total assets
• Debt to equity

Question 2

Debt to EBITDA

Answer 2

Debt/EBITDA

Is used to determine a company’s debt capacity. For example, lenders contemplating lending to a company with EBITDA of $100m restrict the loan amount to 5.0x the company’s EBITDA.

Question 3

Interest coverage ratio

Answer 3

EBIT / interest expense

Analyzes how much in profit is available to satisfy interest expense. Coverage ratios are often included in credit agreements whereby a borrower must maintain a certain ratio to be in good standing with the lender.
• Analysts should understand that since EBIT is a GAAP measure of profitability, it captures many noncash items.
• As a result, sometimes lenders adjust EBIT to better approximate cash profits.

Question 4

Fixed charge coverage

Answer 4

(EBIT + lease charges) / (Lease charges + interest expense)

Analyzes how much in profit is available to satisfy interest expense. Coverage ratios are often included in credit agreements whereby a borrower must maintain a certain ratio to be in good standing with the lender.
• Analysts should understand that since EBIT is a GAAP measure of profitability, it captures many noncash items.
• As a result, sometimes lenders adjust EBIT to better approximate cash profits.

Question 5

Debt to total assets

Answer 5

Total debt / total assets

Question 6

Debt to equity

Answer 6

Total liabilities / Total equity

Is used to understand how levered a company is. The higher the D/E, the more
highly levered a firm is.
• Analysts should note, however, that since the book value of equity can seriously understate market value of equity for many companies, a market value of equity should be used to better understand leverage.