The interest expense to debt ratio allows analysts to estimate the rate of interest a company is paying on their outstanding debt. Analysts can use the interest expense to debt ratio to benchmark the company's cost to borrow against its competitors or peer group.
Calculation
Interest Expense to Debt Ratio = Interest Expense / (Long Term Debt + Short Term Debt)
Note: A company's interest expense can be found on its income statement, while long and short-term debts appear on its balance sheet. These financial statements will be part of the company's Form 10-K filing with the Securities and Exchange Commission.
Explanation
Large corporations raise capital in two ways: they can issue shares of stock (equity) or they can borrow money from lenders (debt). Creditors are compensated by borrowers for the use of the money in addition to the risk of non-payment. Generally, the rate of interest charged will increase as the risk of non-payment increases.
Calculating a company's interest expense to debt ratio allows analysts to benchmark the rate of interest paid against competitors as well as peers. Companies that are experiencing financial distress will have a higher interest expense to debt ratio. Since the debt appearing on a balance sheet of the company is a historical account of the company's need to borrow, it's advisable to look for patterns in this metric over time.
Example
Company A's industry was hit hard by a near term reduction in sales due to an economic recession. Industry analysts were concerned about Company A's financial health and wanted to understand if Company A's cost to borrow is increasing over time.
The information in the table below was pulled from Company A's Form 10-K filings over the past several years. The analyst also pulled the same information for twenty other companies to use as an industry benchmark:
Year 1
Year 2
Year 3
Year 4
Year 5
Interest Expense
$2,498,746
$3,171,485
$5,201,235
$5,291,305
$5,143,641
Long and Short Term Debt
$48,052,800
$52,858,080
$63,429,696
$61,526,805
$58,450,465
Interest Expense to Debt Ratio
5.2%
6.0%
8.2%
8.6%
8.8%
Industry Benchmark
5.5%
6.6%
7.0%
7.1%
7.1%
Based on this information, the analyst concluded Company A is under financial distress. The cost to borrow appears to have increased significantly in Year 3 and continues through Year 5. The industry benchmark information also demonstrates that while the cost to borrow has been increasing, Company A's ratio is significantly higher than expected.
The capital to labor ratio allows analysts to understand if costs are being reduced by purchasing assets to automate labor-intensive tasks. An increase to a company's capital to labor ratio over time can signal an attempt to remain competitive, or improve margins, through automation.
The fringe benefits to salaries expense ratio allows analysts to understand how much a company spends on employee benefits relative to an industry benchmark. A company can analyze its competitive position by benchmarking the cost of its benefits programs relative to the industry or peers. The metric is also useful when analyzing potential savings opportunities during a merger.
The discretionary cost to sales ratio allows analysts to quantify the unrestricted expenses that can be eliminated in the near term. When faced with an economic or industry downturn, companies can bolster profits by eliminating what are deemed optional expenses. Calculating their discretionary cost to sales ratio allows companies to understand the magnitude of this opportunity.
The sales expense to sales ratio allows analysts to understand how efficient a particular sales channel is at generating revenues. Calculating its sales expense to sales ratio allows a company to direct resources to the most effective channels. Companies can also track this metric over time, looking for movements that might indicate a change in consumer purchasing behavior.
The foreign exchange ratio allows analysts to estimate the impact a change in exchange rates has on the net income of a company. As exchange rates change over time, companies are required to recognize both gains and losses on certain transactions or obligations. The foreign exchange ratio allows analysts to understand the impact these changes have on net income.
The term overhead rate refers to a ratio used by analysts to estimate the overhead costs allocated to each unit of production. An increasingly less popular measure, analysts and company management can use the overhead rate to understand the magnitude of costs that are directly related to the manufacture of the company's products.
The term goodwill to assets refers to a ratio used by analysts to estimate the impact the intangible asset goodwill has on a company's balance sheet. SFAS No. 142 instructs companies to write off goodwill as it becomes impaired. Without a need to amortize goodwill over time, it's important for the investor-analyst to understand the affect goodwill has on assets, and whether or not this value is rising or falling over time.
The term overhead to cost of sales ratio is used by analysts to estimate the impact overheads have on the company's cost of goods sold. The overhead to cost of sales ratio provides company management with insights into the growth of overheads as sales increase over time.