What are financial risk ratios and how are they used to measure risk?

Financial risk ratios are primarily used to assess a company's capital structure and current risk level as evaluated in relation to the company's debt level. The ability of a company to manage its outstanding debt effectively is critical to the company's financial soundness and operating ability. Debt levels and debt management also significantly impact a company's profitability, since funds required to service debt reduce net profit margin and cannot be invested in growth.

Some of the financial ratios that are most commonly used by investors and analysts to assess a company's financial risk level and overall financial health include the debt-to-capital ratio, the debt-to-equity ratio, the interest coverage ratio and the degree of combined leverage.

The debt-to-capital ratio is a measure of leverage that provides a basic picture of a company's financial structure in terms of how it is capitalizing its operations and an indication of its financial soundness. The debt-to-capital ratio is simply a comparison of a company's total short-term debt and long-term debt obligations to its total capital provided by both shareholders' equity and debt financing. Lower debt-to-capital ratios are generally preferred, as they indicate a higher proportion of equity financing to debt financing.

The debt-to-equity ratio (D/E) is a key financial ratio that provides a more direct comparison of debt financing to equity financing. It is also an indicator of a company's ability to meet outstanding debt obligations. Again, a lower ratio value is generally preferred, as this indicates the company is financing operations more through its own resources than through taking on debt. Companies with stronger equity positions are usually better able to weather temporary downturns in revenue or unexpected needs for additional capital investment. Higher D/E ratios may negatively impact a company's ability to secure additional financing when needed.

The interest coverage ratio is a basic measure of a company's ability to handle its short-term financing costs. The ratio value reveals the number of times that a company can make the required annual interest payments on its outstanding debt with its current earnings before taxes and interest. A relatively lower coverage ratio indicates a greater debt service burden on the company and a correspondingly greater risk of default or financial insolvency.

A lower ratio value means a lesser amount of earnings available to make financing payments, and it also means the company is less able to handle any increase in interest rates. Generally, an interest coverage ratio of 1.5 or lower is considered indicative of potential financial problems related to debt service. However, an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.

The degree of combined leverage provides a fuller, more complete assessment of a company's total risk by factoring in both operating leverage and financial leverage. This leverage ratio estimates the combined effect of both business risk and financial risk on the company's earnings per share (EPS), given a particular increase or decrease in sales. Calculating this ratio can help management identify the best possible levels and combination of financial and operational leverage for the firm.