How can I track the financial health of a company by analyzing its debt levels?

To analyze a company's financial health through its debt levels, investors should evaluate key financial ratios such as the debt-to-equity ratio, interest coverage ratio, and debt service coverage ratio. Understanding a company's ability to manage debt is essential for making informed investment decisions.

1. Debt-to-Equity (D/E) Ratio

The debt-to-equity ratio compares a company's total debt to its shareholders' equity, indicating financial leverage.

• Formula: Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
• Low ratio: Indicates lower financial risk.
• High ratio: Suggests higher dependence on borrowed funds.

2. Interest Coverage Ratio

This ratio measures a company's ability to pay interest on its debt using its earnings before interest and taxes (EBIT).

• Formula: Interest Coverage Ratio = EBIT / Interest Expense
• Higher ratio: Indicates strong financial health.
• Lower ratio: Suggests potential difficulties in meeting interest payments.

3. Debt Service Coverage Ratio (DSCR)

The DSCR evaluates a company's ability to cover its total debt obligations, including interest and principal repayments.

• Formula: DSCR = Net Operating Income / Total Debt Service
• DSCR above 1: Indicates strong financial stability.
• DSCR below 1: Suggests potential liquidity issues.

4. Leverage Ratio

The leverage ratio measures a company's reliance on debt compared to its total assets.

• Formula: Leverage Ratio = Total Debt / Total Assets
• Lower ratio: Indicates financial stability.
• Higher ratio: Suggests greater financial risk.

5. Free Cash Flow to Debt Ratio

This ratio determines how well a company can manage its debt using free cash flow.

• Formula: Free Cash Flow to Debt = Free Cash Flow / Total Debt
• Higher ratio: Indicates a company's ability to pay off debt.
• Lower ratio: Suggests possible liquidity issues.