The most inclusive and most useful debt management ratios are the composition ratios drawn from a vertical analysis of the right side of the balance sheet. Note the liability and equity composition ratios in the right-hand column of Figure 2.4 in the section “Vertical Analysis”. These percentage composition ratios indicate the relative proportions of various forms of debt and owners’equity used to finance the organization. The vertical analysis of Sample Company’s sources of funds shows that 33.8% of all financing came from current liabilities. A smaller amount (24.4%) came from longterm liabilities, and the largest portion (41.8%) came from owners. Of the 41.8% portion that came from owners, 29.3% was in the form of direct investment, and 12.5% was in the form of profits reinvested in the business.
The ratio of total debt to total assets, also called the debt-to-assets ratio, is often used as a primary indicator of the firm’s debt management. Figure 2.4 in the section “Vertical Analysis” shows that Sample Company’s total liabilities are equal to 58.2% of total assets. As this key ratio increases or decreases, it indicates the firm’s changing reliance on borrowed resources. The lower the ratio, the lower the firm’s risk because the organization will usually be better able to meet its obligations for interest and debt payments. A lower debt-to-assets ratio also suggests a lower risk of default. Default on a firm’s liabilities is a costly event from both a lender’s and a borrower’s perspective and should be avoided if at all possible.
The fact that Sample Company’s owners’ equity provides 41.8% of the firm’s resources suggests that the owners’ equity of this firm offers substantial protection to lenders. Suppose, for example, Sample Company was unable to continue its operations and had to liquidate its assets, or, in other words, convert its assets to cash. In such a situation, Sample Company could incur losses of 41.8% of the assets’ carrying value, and the cash received would still be sufficient to pay off all the firm’s debts. Of course, nothing would then be left for the owners.