A variety of equity valuation metrics can be utilized to evaluate a company along with the debt to capital ratio to get a more complete picture of the company’s viability as an investment.
The debt to equity ratio can be used as an alternative measure to evaluate a company’s debt situation. This ratio measures how much financial leverage a company has, dividing a company’s total liabilities by its shareholders’ equity. When the debt to equity ratio is high, it generally indicates that the company has used a significant amount of debt to fund its growth. However, large amounts of debt financing could potentially generate increased earnings, which could be sufficient to outweigh debt costs and still return equity to shareholders. On the other hand, the costs of financing through debt could also overpower any returns generated by the company and may be too much for it to sustain.
What is perhaps more important than a company’s total debt is its ability to service its outstanding debt. Debt in itself is not problematic as long as the company can make the required payments. Neither the debt to capital ratio nor the debt to equity ratio factor in a company’s ability to cover its debt or that companies borrow at different interest rates. The interest coverage ratio accounts for these factors. Instead of looking simply at total debt, the calculation for this metric includes the cost a company pays in interest as it relates to the company’s operating income. The formula for this ratio divides a company’s operating income by its interest expense; a higher number is better. Typically, an interest coverage ratio of 3 or higher indicates a company with a strong ability to cover its debt, but acceptable ratio levels vary between industries.
A number of profitability ratios can be utilized to evaluate a company’s performance in regard to generating profits, such as the return on equity ratio and the return on assets ratio. The return on equity ratio measures a shareholder’s actual earnings on his investment in a company. The return on assets ratio is more broad, expressing how profitable a company is in relationship to its total assets. This metric helps assess how well a company’s management is engaging its total assets to turn a profit. Calculating this metric compares the company’s net income to its total assets. When the resulting value of the return on assets ratio is higher, it indicates that the company’s management is utilizing its asset base more effectively.
These and other equity measures can be used to gain an overall assessment of a company’s financial health and performance. Investors should never rely on a single evaluation metric, but instead should analyze the company from a variety of perspectives.