4.5. Leverage indicators

Average cost of debt

The average cost of (interest bearing) debt is relevant to understand the cost of financing by third parties. It is common to observe that firms hold different types of products of debt, which differ not only in interest rates, as time length wise, commissions and other fees.

It won’t make sense to determine that the cost of financing of the company is its long-term bank loans if the debt has mostly short-term loans and equivalents (although short-term financing can be renewed over the periods). To meet the average cost of debt, you should use the following:

  • \(Average\ cost\ of\ debt=\frac{Interest\ costs}{Interest\ bearing\ debt}\)

Interest bearing debt includes bonds, bank loans and equity holders’ loans.

Debt capacity

This ratio provides a comparison between a company’s equity and its permanent capital (which includes equity, but also forms of long-term debt.

  • \(Debt\ capacity=\frac{Equity}{Permanent\ capital}\)

Interest coverage ratio

The coverage of financial charges demonstrates the company’s ability to generate sufficient operational funds to pay interests costs. A simplified form assumes that the EBITDA corresponds roughly to the cash flows that the company generates.

  • \(Interest\ coverage\ ratio=\frac{EBIT}{Interest\ costs}\)

If the ratio is higher than 1, the company is generating sufficient funds to pay the interest costs and if it is less the opposite. A ratio less than 1 does not mean that the company cannot pay its interest costs. By resorting to surplus cash or to a change in working capital investment, the company may be able to meet its obligations.

You should be aware that this ratio is often calculated with the EBITDA rather than the EBIT on the numerator.

Debt service coverage rate

It is not just interest costs that are relevant, but also of the principal payments of bank loans. Debt service includes costs and the balance of disbursements and repayments of bank loans. The financial debt structure is composed of short-term and long term, whose terms of payments are usually set under contract. The coverage of the debt payments reflects the company’s ability to generate funds to pay its debt service.

  • \(Debt\ service\ coverage\ ratio=\frac{Operational\ cash\ flows}{Debt\ service}\)

Cash ratio

The cash ratio establishes the proportion of the constant values of cash and bank deposits and loans obtained by the company.

  • \(Cash\ ratio=\frac{Cash\ and\ deposits}{Current\ debt+non\ current\ debt}\)

Next Section: 4.6. Liquidity ratios