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FINANCIAL STATEMENT ANALYSIS
Implications of
using debt to
capitalize
This use of debt as a source of capital has three important implications:
1.
By using debt, control of the firm is achieved with limited
equity investment.
2.
If only a small percentage of the total funds are invested by
equity holders, then creditors bear the risks of the company. For
this reason, creditors often require a certain percentage of equity-
invested funds as a margin of safety.
3.
By leveraging the owners' (equity investors') capital, return on
investment is increased if the firm earns more on the use of the
borrowed funds than it pays in interest.
Use of debt to
finance assets
Analysts have developed ratios to determine the extent of the use of
borrowed funds to finance assets and to determine how many times
the income generated by those assets can be used to make interest
payments. These ratios include:
·
Total Debt to Total Assets Ratio
·
Times Interest Earned (TIE) Ratio
·
Fixed Charge Coverage Ratio
Total Debt to Total Assets Ratio (Debt Ratio)
Percentage of
total funds from
debt
The Total Debt to Total Assets Ratio measures the percentage of
total funds provided by the use of debt. It is calculated by dividing
T
OTAL
D
EBT
(L
IABILITIES
)
by
T
OTAL
A
SSETS
.
Debt Ratio
=
(Total Debt) / (Total Assets)
=
($61.4 + $107.4) / ($286.9)
=
58.8%
Notice that
T
OTAL
D
EBT
includes
C
URRENT
L
IABILITIES
and
L
ONG
-
TERM
D
EBT
.
This Debt Ratio is used by creditors to help decide if they will
loan money to the company.