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Wiley CIAexcel Exam Review 2014: Part 3, Internal Audit Knowledge Elements by S. Rao Vallabhaneni

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(C) Debt Management Ratios

Debt management ratios or coverage ratios are used in predicting the long-run solvency of organizations. Bondholders are interested in these ratios because they provide some indication of the measure of protection available to bondholders. For those interested in investing in an organization’s common stock, these ratios indicate some of the risk, since the addition of debt increases the uncertainty of the return on common stock.

Debt Ratio: Total Debt Divided by Total Assets

Debt ratio impacts an organization’s ability to obtain additional financing. It is important to creditors because it indicates an organization’s ability to withstand losses without impairing the creditor’s interest. A creditor prefers a low ratio since it means there is more cushion available to it if the organization becomes insolvent. However, owners prefer a high debt ratio to magnify earnings due to leverage or to minimize loss of control if new stock is issued instead of taking on more debt. Total debt includes both current liabilities and long-term debt.

The capitalization of a lease by a lessee will result in an increase in the debt-to-equity ratio. If a firm purchases a new machine by borrowing the required funds from a bank as a short-term loan, the direct impact of this transaction will be to decrease the current ratio and increase the debt ratio.

Times-Interest-Earned Ratio: Earnings Before Interest and Taxes Divided by Interest Charges

The times-interest-earned ratio ...

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