The amount of debt a company is responsible for is an important factor when assessing its relative strength and financial stability. Whether you are the business owner, an accountant or an outside party looking at a potential investment, a company's debt level plays a crucial role in numerous financial decisions. Most often expressed as a ratio or percentage, debt levels can be measured in relation to the funds a company has to cover those debts, though some are more comprehensive than others. Two types of debt measurement ratios commonly used are the interest coverage ratio and the debt-service coverage ratio, or DSCR. Though they both give important insights into the financial stability of a company, their calculations and interpretations differ in important ways.
The interest coverage ratio serves to measure the amount of a company's equity compared to the amount of interest it must pay on all debts for a given period. This is expressed as a ratio and is most often computed on an annual basis. To calculate the interest coverage ratio, simply divide the earnings before interest and taxes, or EBIT, for the established period by the total interest payments due for that same period. EBIT, often called net operating income or operating profit, is calculated by subtracting overhead and operating expenses, such as rent, cost of goods, freight, wages and utilities, from revenue. This number reflects the amount of cash available after subtracting all expenses necessary to keep the business running. The higher the ratio of EBIT to interest payments, the more financially stable the company. This metric only takes into account interest payments and not payments made on principal debt balances that may be required by lenders.
The debt-service coverage ratio is slightly more comprehensive. This metric assesses the ability of a company to meet its minimum principal and interest payments, including sinking fund payments, for a given period. To calculate DSCR, EBIT is divided by the total amount of principal and interest payments required for a given period. Because it takes into account principal payments in addition to interest, the DSCR is a slightly more robust indicator of a company's financial fitness.
In either case, a company with a ratio of less than 1 does not generate enough revenue to cover its minimum debt expenses. In terms of business management or investment, this represents a very risky prospect since even a brief period of lower-than-average income could spell disaster. A company with an interest coverage ratio or DSCR of less than 1 is able to generate enough revenue to keep the lights on but not meet its debt obligations. Therefore, companies with higher ratios are considered by investors and lending institutions to be more financially stable. Banks, for example, are unlikely to lend funds to a company with a DSCR of 0.89 because it reflects a struggle to make minimum payments on current obligations. Generally, a ratio of less than 1.5:1 or 150% is considered high risk. Of course, both ratios can change dramatically as the company takes on new debt, pays off old debt or experiences revenue fluctuations.