What Are Financial Risk Ratios and How Are They Used to Measure Risk?

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Part of the Series Guide to Financial Ratios

Overview of Financial Ratios

  1. Guide to Financial Ratios
  2. Measures of a Company's Financial Health
  3. Financial Risk Ratios to Measure Risk
CURRENT ARTICLE
  1. Return on Assets (ROA)
  2. Return on Equity (ROE)
  3. Return on Investment (ROI)
  4. Return on Invested Capital (ROIC)
  5. EBITDA Margin
  6. Net Profit Margin
  7. Operating Margin
  1. Current Ratio
  2. Quick Ratio
  3. Cash Ratio
  4. Operating Cash Flow Ratio
  5. Receivables Turnover Ratio
  6. Inventory Turnover
  7. Working Capital Turnover Definition
  1. Debt-To-Equity Ratio
  2. Total-Debt-to-Total-Assets Ratio
  3. Interest Coverage Ratio
  4. Shareholder Equity Ratio
  1. Price-to-Earnings Ratio
  2. Price-to-Book Ratio
  3. Price-to-Sales Ratio
  4. Price-to-Cash Flow Ratio

Financial ratios can be used to assess a company's capital structure and current risk levels, often in terms of a company's debt level and risk of default or bankruptcy. These ratios are used by investors when they are considering investing in a company. Whether a firm can manage its outstanding debt is critical to the company's financial soundness and operating ability. Debt levels and debt management also significantly impact a company's profitability, since funds required to service debt reduce the net profit margin and cannot be invested in growth.

Some of the financial ratios commonly used by investors and analysts to assess a company's financial risk level and overall financial health include the debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the degree of combined leverage (DCL).

Key Takeaways

Debt-to-Capital Ratio

The debt-to-capital ratio is a measure of leverage that provides a basic picture of a company's financial structure in terms of how it is capitalizing its operations. The debt-to-capital ratio is an indicator of a firm's financial soundness. This ratio is simply a comparison of a company's total short-term debt and long-term debt obligations with its total capital provided by both shareholders' equity and debt financing.

Debt/Capital = Debt / (Debt + Shareholders' Equity)

Lower debt-to-capital ratios are preferred as they indicate a higher proportion of equity financing to debt financing.

Debt-to-Equity Ratio

The debt-to-equity ratio (D/E) is a key financial ratio that provides a more direct comparison of debt financing to equity financing. This ratio is also an indicator of a company's ability to meet outstanding debt obligations.

Debt/Equity = Debt / Shareholders' Equity

​Again, a lower ratio value is preferred as this indicates the company is financing operations through its own resources rather than taking on debt. Companies with stronger equity positions are typically better equipped to weather temporary downturns in revenue or unexpected needs for additional capital investment. Higher D/E ratios may negatively impact a company's ability to secure additional financing when needed.

A higher debt-to-equity (D/E) ratio may make it harder for a company to obtain financing in the future.

Interest Coverage Ratio

The interest coverage ratio is a basic measure of a company's ability to handle its short-term financing costs. The ratio value reveals the number of times that a company can make the required annual interest payments on its outstanding debt with its current earnings before interest and taxes (EBIT). A relatively lower coverage ratio indicates a greater debt service burden on the company and a correspondingly higher risk of default or financial insolvency.

Interest Coverage = EBIT / Interest Expense

A lower ratio value means a lesser amount of earnings available to make financing payments, and it also means the company is less able to handle any increase in interest rates. Generally, an interest coverage ratio of 1.5 or lower is considered indicative of potential financial problems related to debt service. However, an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.

Investors consider that a company with an interest coverage ratio of 1.5 or lower is likely to face potential financial problems related to debt service.

Degree of Combined Leverage

The degree of combined leverage (DCL) provides a more complete assessment of a company's total risk by factoring in both operating leverage and financial leverage. This leverage ratio estimates the combined effect of both business risk and financial risk on the company's earnings per share (EPS), given a particular increase or decrease in sales. Calculating this ratio can help management identify the best possible levels and combination of financial and operational leverage for the firm.

DCL = % Change EPS / % Change Sales

A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage because high leverage means more fixed costs to the firm.

The Bottom Line

Financial ratios are used in fundamental analysis to help value companies and estimate their share prices. Certain financial ratios can also be used to evaluate a firm's level of risk, especially as it relates to servicing debts and other obligations over the short and long run.

This analysis is used by bankers to grant additional loans and by private equity investors to decide investments in companies and use leverage to pay back debt on their investments or augment their return on investments.

Article Sources
  1. Michighan State University Libraries, Pressbooks. "Financial Management for Small Businesses: Financial Statements & Present Value Models: 5, Financial Ratios."
  2. Moszoro, Marian. "The Big Picture of Corporate Finance." IESE Business School, University of Navarra, OP-257-E, January 2014, pp. 6.
Part of the Series Guide to Financial Ratios

Overview of Financial Ratios

  1. Guide to Financial Ratios
  2. Measures of a Company's Financial Health
  3. Financial Risk Ratios to Measure Risk
CURRENT ARTICLE
  1. Return on Assets (ROA)
  2. Return on Equity (ROE)
  3. Return on Investment (ROI)
  4. Return on Invested Capital (ROIC)
  5. EBITDA Margin
  6. Net Profit Margin
  7. Operating Margin
  1. Current Ratio
  2. Quick Ratio
  3. Cash Ratio
  4. Operating Cash Flow Ratio
  5. Receivables Turnover Ratio
  6. Inventory Turnover
  7. Working Capital Turnover Definition
  1. Debt-To-Equity Ratio
  2. Total-Debt-to-Total-Assets Ratio
  3. Interest Coverage Ratio
  4. Shareholder Equity Ratio
  1. Price-to-Earnings Ratio
  2. Price-to-Book Ratio
  3. Price-to-Sales Ratio
  4. Price-to-Cash Flow Ratio
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Combined loan-to-value (CLTV) ratio is the ratio of all loans on a property to the property's value. Lenders use it to determine risk of default.

The equity multiplier is a calculation of how much of a company’s assets is financed by stock rather than debt. For investors, it is a risk indicator.

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The fixed asset turnover ratio measures how efficiently a company is generating net sales from its fixed-asset investments.

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The asset coverage ratio determines a company's ability to cover debt obligations with its assets after all liabilities have been satisfied.

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