Financial risk ratios examine a company's ability to meet all liability obligations and the impact of these liabilities on the balance sheet structure.
Times interest earned, or interest coverage ratio, is the traditional measure of a company's ability to meet its interest payments. Times interest earned indicates how well a company is able to generate earnings to pay interest. The larger and more stable the ratio, the less risk of default. Interest on debt obligations must be paid, regardless of company cash flow. Failure to do so results in default if the lender will not restructure the debt obligations.
The debt-to-total-assets ratio measures the percentage of assets financed by all forms of debt. The higher the percentage and the greater the potential variability of earnings translate into a greater potential for default. Yet, prudent use of debt can boost return on equity.
The debt-to-total-capital ratio is a popular measure of financial leverage, but its name may cause confusion. Debt for this ratio consists only of long-term debt, not total debt. Capital refers to all sources of long-term financing—long-term debt and stockholder's equity. This ratio is interpreted in the same way as the debt-to-total-assets ratio; a high ratio indicates high risk. However, a low level may not be an indication of low risk if current liabilities are high.
