How Are Financial Risk Ratios Used To Measure Risk?

How Are Financial Risk Ratios Used To Measure Risk?

By CFO Tech Outlook | Tuesday, January 28, 2020

Business risk ratios are used to examine the capital structure of a company. It is necessary to examine the capital structure once in a while because an overly risky capital structure that relies too heavily on debt can squeeze the best company.

FREMONT, CA: In order to assess a company’s capital structure and risk level in relation to the debt level, financial risk ratios are required. Investors can also use these processes before investing in a company. Here are three methods which are commonly used to examine business risk:

Debt-to-Capital Ratio

To get a primary picture of a company’s financial structure in terms of how it is capitalizing its operations, the debt-to-capital ratio is needed. This ratio indicates a firm’s financial soundness. This ratio is a comparison of a company’s total short-term debt and long-term debt obligations with its total capital provided by both shareholders’ equity and debt financing. 

Debt-to-Equity Ratio

The other ratio, which is known as the debt-to-equity ratio (D/E), provides a more direct comparison of debt financing to equity financing. This ratio indicates a company’s strength to meet other debt obligations. If the value of the rate is less, then it is preferred more because this shows the company is financing operations through its resources rather than taking on debt. If the ratio is high, it may negatively impact a company’s capability to secure additional financing when required.

Interest Coverage Ratio

The interest coverage ratio may be a primary measure of a firm’s ability to handle its short-term financing costs. The ratio value shows the number of times that a corporation can make the specified annual interest payments on its outstanding debt with its current earnings before taxes and interest. A comparatively lower coverage ratio indicates a more significant debt service burden on the corporate and a correspondingly higher risk of financial insolvency.

A lower ratio value means a lesser amount of earnings available to form financing payments, and it also means the corporation is a smaller amount ready to handle any hike in interest rates. However, an excessively high rate can indicate the corporate is failing to require advantage of its available financial leverage.

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