Debt Ratios

First, we have the total debt ratio, which aims to answer, “How much in assets do we have due to our debt?” In other words, for every $1 of assets, how much do we have in debt?

Total Debt Ratio = Total Liabilities / Total Assets 

Now, let’s add more numbers to our example. From before, we know our total assets are $52,000, and our current liabilities were $12,000.

Let’s say we have long-term liabilities of $25,000, giving us total liabilities of $37,000.

Then we divide $37,000 of liabilities by $52,000 of assets, which is 71%.

This means that for every $1 of total assets, we have $0.71 of debt. 

Debt-to-Equity Ratio

Now, let’s examine the debt-to-equity ratio. Each company only has two options for raising cash, either through debt or through equity. The debt-to-equity ratio tries to answer how much you’ve raised through debt versus equity. Remember, anytime we have a formula like debt-to-equity, the second name is what goes in the denominator. 

Debt-to-Equity Ratio = Total Debt / Total Equity

Our assets were $52,000. Our liabilities were $37,000, meaning our equity is $15,000. $37,000 divided by $15,000 is approximately 2.5. That means that for every $1 raised through equity, we raised $2.50 in debt.

Times Interest Earned Ratio

The next ratio is times interest earned. This attempts to answer how capable we are of paying our interest payments. We’re going to look at our income before interest or taxes and then compare it to our interest expense. The higher the number, the better, because that means we’re more capable of making our interest payments. 

Times Interest Earned = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Now, let’s insert some numbers into this equation. We know from earlier our net income is $5,100. Let’s say our interest expense is $1,000 and our tax is $900. We add those back to the net income. Now, we have $7,000 in the numerator. We divide $7,000 by the interest expense of $1,000. Our time's interest earned is therefore 7. That means we can cover our interest payment seven times over. In other words, we would be able to pay our interest if it increased up to seven times its current amount.