Total Capitalization versus Total Assets Frequently, financial analysts are more concerned with a firm’s long-term debt than its short-term debt because the short-term debt will constantly be changing. Also, a firm’s accounts payable may reflect trade practice more than debt management policy. For these reasons, the long-term debt ratio is often calculated as follows:
The $3,048 in total long-term debt and equity is sometimes called the firm’s total capitalization, and the financial manager will frequently focus on this quantity rather than on total assets.
To complicate matters, different people (and different books) mean different things by the term debt ratio. Some mean a ratio of total debt, some mean a ratio of long-term debt only, and, unfortunately, a substantial number are simply vague about which one they mean.
This is a source of confusion, so we choose to give two separate names to the two measures. The same problem comes up in discussing the debt–equity ratio. Financial analysts frequently calculate this ratio using only long-term debt.
Times Interest Earned Another common measure of long-term solvency is the times interest earned (TIE) ratio. Once again, there are several possible (and common) definitions, but we’ll stick with the most traditional:
Ratios used to analyze technology firms can be found at www.chalfin.com under the “Publications” link.
Page 62As the name suggests, this ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. For Prufrock, the interest bill is covered 4.9 times over.
Cash Coverage A problem with the TIE ratio is that it is based on EBIT, which is not really a measure of cash available to pay interest. The reason is that depreciation, a noncash expense, has been deducted out. Because interest is definitely a cash outflow (to creditors), one way to define the cash coverage ratio is this:
The numerator here, EBIT plus depreciation, is often abbreviated EBITD (earnings before interest, taxes, and depreciation—say “ebbit-dee”). It is a basic measure of the firm’s ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations.
A common variation on EBITD is earnings before interest, taxes, depreciation, and amortization (EBITDA—say “ebbit-dah”). Here amortization refers to a noncash deduction similar conceptually to depreciation, except it applies to an intangible asset (such as a patent) rather than a tangible asset (such as a machine). Note that the word amortization here does not refer to the repayment of debt, a subject we discuss in a later chapter.