Understanding and Calculating Financial Risk: A Comprehensive Guide

Financial risk in the investment world is measured in terms of debt. Those companies which issue more debt are said to have higher financial risk. This is in contrast to companies which are primarily financed with equity. One of the most common metrics used to measure financial risk is EBIT. Two other common metrics look at how many times a company can pay its debt and/ or interest payments with earnings.

Step 1

Calculate EBIT. EBIT is earnings before interest and taxes. It is calculated with the following formula: sales - cost of goods sold - operating expenses = EBIT. You can find this information on the income statement within the 10K, 10Q or annual report.

Step 2

Calculate debt capacity ratio. The debt capacity ratio is EBIT / "debt payments due." This should be compared against other companies in the same industry. This ratio is also known as the Debt Service Ratio (DSR) as it represents the number of debt payments that can be made with current free cash flow. Another way to look at it is an an indicator of a company's financial "cushion."

Step 3

Calculate interest coverage ratio. The formula is EBIT / "interest expenses." The interest expense should cover the same period as the EBIT calculation. In general, a company should be able to meet its interest expenses at least two to three times in order to be considered financially secure. Anything lower is a sign of financial weakness.