Rock-bottom interest rates have shielded many highly indebted companies from financial difficulties over recent years. Indeed, rates have been at or below 0.75pc for 13 years.

Now, though, a new era of less accommodative monetary policy appears to have commenced. The Bank of England has increased interest rates at its past two meetings, with four of its nine members voting for an even greater rise than the 0.25 percentage point increase at its latest meeting.

Higher borrowing costs could cause severe challenges for firms with large amounts of debt. For example, a larger proportion of their profit may be required to service borrowings. This may inhibit dividend growth and could mean they fail to reinvest in long-term growth opportunities. As a result, their share price prospects could be compromised.

In Questor’s view, assessing the financial standing of firms will become increasingly important in the coming years. Clearly, predicting precisely how high interest rates will rise is a “known unknown”. But, as the pandemic recedes and inflation remains significantly above target, further interest rate rises seem inevitable.

The debt-to-equity ratio is a simple means of assessing a company’s financial leverage. It compares a firm’s borrowings to shareholders’ equity and provides a snapshot of how reliant it is on debt to finance its operations. The ratio is calculated by dividing total debt by shareholders equity, both of which are located on the balance sheet.

For example, recent tip BHP has total debt of around £15.5bn and shareholder equity of £41.2bn. This gives a debt-to-equity ratio of around 0.38. This means that for every £1 of shareholder equity, BHP is using £0.38 of debt to fund its operations.

Some investors may have specific parameters on what they consider an acceptable debt-to-equity ratio. For instance, they may choose to avoid firms with a ratio above one. However, two companies with the same ratio can offer very different risk profiles.

For instance, BHP’s business is highly dependent on commodity prices that are unpredictable and volatile. By contrast, firms operating in more stable industries, such as utility or tobacco companies, have far more reliable revenue streams that  mean they are able to withstand a greater amount of leverage. As a result, interpreting the debt-to-equity ratio requires consideration of a firm’s operating environment and business model.

Of course, the debt-to-equity ratio is not a foolproof measure of a company’s capacity to withstand higher interest rates. Indeed, checking how much headroom a firm has when making interest payments may offer insight into how it will perform amid an increasingly hawkish monetary policy environment.

The interest coverage ratio states how many times a company could afford to pay its debt servicing costs over a given period. It is calculated by dividing operating profit, which is also known as earnings before interest and tax, by interest payments. Both figures can be found on the income statement.

Returning to the earlier example, BHP’s operating profit in the 2021 financial year was £19.2bn. It paid just over £1bn in finance costs, which means its interest coverage ratio was around 19.

As a result, its profit could fall considerably, or finance costs could rise substantially, before it is unable to service existing debt. As with the debt-to-equity ratio, the stability and reliability of a firm’s financial performance will affect what is viewed as an acceptable ratio by investors.

Undoubtedly, there are other useful measures that can be used to assess the financial health of a business. However, in Questor’s view, the debt-to-equity and interest coverage ratios offer a simple means to quickly assess financial standing.

Their relevance may have become diluted over recent years, as some investors and companies assumed that low interest rates would persist indefinitely. But their importance, as part of a wider investment checklist, could increase significantly as rising interest rates expose that firms have failed to sensibly manage their finances.

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