Going Concern Debt Ratios: Is the Firm Safe?

Abstract:     
Traditionally, the maximum debt ratio of a balance sheet has been thought to be determined by the quality of total assets. That is, creditors want fewer other creditors (low debt ratio) when most of the assets are of lower quality (fixed assets). Conversely, higher debt ratios are tolerated by creditors when assets are of higher quality (primarily receivables). Thus, the credit markets will allow higher debt ratios for a finance company than they would for a heavy manufacturer. In this respect, a debt ratio is thought to be a liquidation ratio. That is, when corporate assets are liquidated by a bankrupt referee, higher quality assets will generate a larger quantity of proceeds than lower quality assets. Such an approach ignores the concept of a debt ratio as a going concern ratio. That is, how much do sales have to decline before earnings go negative. We demonstrate a simple method for determining degree of total leverage breakeven and whether or not the firm is safe. We demonstrate that debt ratios as compared with some industry benchmark can be poor indicators of firm safety.

Number of Pages in PDF File: 9

Keywords: debt ratio, degree total leverage, degree of total leverage

JEL Classification: G21, G24, G32, B33

Accepted Paper Series