Chapter 28 Financial Analysis 745
bre44380_ch28_732-758.indd 745 10/06/15 09:49 AM
Long-term debt ratio =
long-term debt
____________________
long-term debt + equity=
14,691
______________
14,691 + 12,522= .54, or 54%This means that 54 cents of every dollar of long-term capital is in the form of debt.
Leverage is also measured by the debt–equity ratio. For Home Depot,
Long-term debt–equity ratio =
long-term debt
____________
equity=
14,691
______
12,522= 1.17, or 117%Home Depot’s long-term debt ratio is on the high side for U.S. nonfinancial companies, but
some companies deliberately operate at much higher debt levels. For example, in Chapter 32
we look at leveraged buyouts (LBOs). Firms that are acquired in a leveraged buyout usually
issue large amounts of debt. When LBOs first became popular in the 1990s, these companies
had average debt ratios of about 90%. Many of them flourished and paid back their debthold-
ers in full; others were not so fortunate.
Notice that debt ratios make use of book (i.e., accounting) values rather than market values.^13
The market value of the company finally determines whether the debtholders get their money
back, so you might expect analysts to look at the face amount of the debt as a proportion of the
total market value of debt and equity. On the other hand, the market value includes the value
of intangible assets generated by research and development, advertising, staff training, and so
on. These assets are not readily salable and, if the company falls on hard times, their value
may disappear altogether. For some purposes, it may be just as good to follow the accountant
and ignore these intangible assets. This is what lenders do when they insist that the borrower
should not allow the book debt ratio to exceed a specified limit.
Notice also that these measures of leverage ignore short-term debt. That probably makes
sense if the short-term debt is temporary or is matched by similar holdings of cash, but if the
company is a regular short-term borrower, it may be preferable to widen the definition of debt
to include all liabilities. In this case,
Total debt ratio = total liabilities____
total assets=
27,9 9 6
______
4 0,518= .69, or 69%Therefore, Home Depot is financed 69% with long- and short-term debt and 31% with equity.^14
We could also say that its ratio of total debt to equity is 27,996/12,522 = 2.24.
Managers sometimes refer loosely to a company’s debt ratio, but we have just seen that the debt
ratio may be measured in several different ways. For example, Home Depot has a debt ratio of
.54 (the long-term debt ratio) and also .69 (the total debt ratio). This is not the first time we have
come across several ways to define a financial ratio. There is no law stating how a ratio should be
defined. So be warned: do not use a ratio without understanding how it has been calculated.
Times-Interest-Earned Ratio Another measure of financial leverage is the extent to which
interest obligations are covered by earnings. Banks prefer to lend to firms whose earnings
cover interest payments with room to spare. Interest coverage is measured by the ratio of earn-
ings before interest and taxes (EBIT) to interest payments. For Home Depot,^15
Times-interest-earned = _______________EBIT
interest payments=
9,178
_____
711= 12.9(^13) In the case of leased assets, accountants estimate the value of the lease commitments. In the case of long-term debt, they simply
show the face value, which can be very different from market value. For example, the present value of low-coupon debt may be only a
fraction of its face value. The difference between the book value of equity and its market value can be even more dramatic.
(^14) In this case, the debt consists of all liabilities, including current liabilities.
(^15) The numerator of times-interest-earned can be defined in several ways. Sometimes depreciation is excluded. Sometimes it is just
earnings plus interest, that is, earnings before interest but after tax. This last definition seems nutty to us, because the point of times-
interest-earned is to assess the risk that the firm won’t have enough money to pay interest. If EBIT falls below interest obligations, the
firm won’t have to worry about taxes. Interest is paid before the firm pays taxes.