Several financial ratios are commonly used by investors and analysts to measure a company's level of risk, particularly its financial risk related to debt and leverage.
Understanding Financial Risk Ratios
Financial risk ratios help stakeholders assess a company's ability to meet its debt obligations and manage its leverage. By analyzing these ratios, investors can gain insight into how much debt a company uses and how easily it can cover its interest payments. Higher levels of debt often translate to higher financial risk, as the company has fixed interest payments regardless of its profitability.
Based on common practices in financial analysis, the most frequently utilized ratios for measuring a company's risk profile include those focused on its debt structure and ability to service debt.
Key Ratios for Measuring Risk
According to financial analysis principles, the most common ratios used by investors to measure a company's level of risk are:
- Interest Coverage Ratio: This ratio measures a company's ability to pay interest expenses on its outstanding debt. It is calculated by dividing Earnings Before Interest and Taxes (EBIT) by interest expenses. A higher ratio indicates that a company can more easily cover its interest obligations, suggesting lower financial risk.
- Example: If a company has EBIT of $1,000,000 and interest expenses of $200,000, its interest coverage ratio is 5x. This means its earnings are 5 times greater than its interest payments.
- Degree of Combined Leverage (DCL): This ratio measures how changes in sales revenue affect a company's earnings per share (EPS). It considers both operating leverage (fixed operating costs) and financial leverage (fixed interest costs). A high DCL indicates that a small change in sales can lead to a large change in EPS, signifying higher risk (both upside and downside).
- Insight: DCL is useful for understanding the sensitivity of profits to sales fluctuations when a company has significant fixed costs, whether operational or financial.
- Debt-to-Capital Ratio: This ratio indicates the proportion of a company's capital structure that is financed by debt. It is calculated by dividing total debt by total capital (total debt plus equity). A higher debt-to-capital ratio suggests that a company relies more heavily on debt financing, potentially increasing its financial risk.
- Practical Use: Banks and creditors often look at this ratio to assess a company's borrowing capacity and solvency.
- Debt-to-Equity Ratio: Similar to the debt-to-capital ratio, this measures the proportion of debt a company uses relative to its equity financing. It's calculated by dividing total debt by total shareholder equity. A higher ratio generally indicates greater financial leverage and higher risk.
- Solution Insight: While a high ratio can signal risk, the 'ideal' ratio varies significantly by industry. Capital-intensive industries like utilities often have higher debt-to-equity ratios than tech companies.
These ratios provide different perspectives on a company's financial health and its exposure to risk stemming from its financing decisions. Analyzing them together offers a more comprehensive view for investors.
