Debt Management Ratios 381
MicroDrive’s ratio is somewhat below the industry average, indicating that the com-
pany is not generating a sufficient volume of business given its total asset investment.
Sales should be increased, some assets should be sold, or a combination of these steps
should be taken.
Identify four ratios that are used to measure how effectively a firm is managing
its assets, and write out their equations.
How might rapid growth distort the inventory turnover ratio?
What potential problem might arise when comparing different firms’ fixed assets
turnover ratios?
Debt Management Ratios
The extent to which a firm uses debt financing, or financial leverage,has three im-
portant implications: (1) By raising funds through debt, stockholders can maintain
control of a firm without increasing their investment. (2) If the firm earns more on in-
vestments financed with borrowed funds than it pays in interest, then its shareholders’
returns are magnified, or “leveraged,” but their risks are also magnified. (3) Creditors
look to the equity, or owner-supplied funds, to provide a margin of safety, so the
higher the proportion of funding supplied by stockholders, the less risk creditors face.
Chapter 13 explains the first two points in detail, while the following ratios examine
leverage from a creditor’s point of view.
How the Firm Is Financed: Total Liabilities to Total Assets
The ratio of total liabilities to total assets is called the debt ratio, or sometimes the
total debt ratio.It measures the percentage of funds provided by sources other than
equity:
Creditors prefer low debt ratios because the lower the ratio, the greater the cushion
against creditors’ losses in the event of liquidation. Stockholders, on the other hand,
may want more leverage because it magnifies expected earnings.
MicroDrive’s debt ratio is 53.2 percent, which means that its creditors have
supplied more than half the total financing. As we will discuss in Chapter 13,
a variety of factors determine a company’s optimal debt ratio. Nevertheless,
the fact that MicroDrive’s debt ratio exceeds the industry average raises a red
flag and may make it costly for MicroDrive to borrow additional funds with-
out first raising more equity capital. Creditors may be reluctant to lend the
firm more money, and management would probably be subjecting the firm to
the risk of bankruptcy if it increased the debt ratio by borrowing additional
funds.
If you use a debt ratio that you did not calculate yourself, be sure to find out how
the ratio was defined. Some sources provide the ratio of long-term debt to total assets,
Industry average40.0%.
$310$754
$2,000
$1,064
$2,000
53.2%.
Debt ratio
Total liabilities
Total assets
Analysis of Financial Statements 377
