Introduction:
You realize that your business needs to expand to meet clients’ demands or decide to benefit from available opportunities. But your funds do not match your need; what do you do? You borrow, debt becomes part of your business financing. Your financing structure becomes capital and external funds (debt). Wait, debt should not be viewed as bad; instead, we need to view it as part of a successful plan to achieve our goals. In this post, we will discuss how to analyze the use of debt in our business with debt management ratios. Remember that debt management ratios are part of our series of financial ratios.
The importance of debt
Debt should be used with caution. But creating a well-balanced debt plan has its benefits. For example, if owners provide all funding, the risk of loss remains with them; instead, using financing shifts all the burden from the owners to the creditors. Therefore, debt helps in balancing the risk and return of business investing. Moreover, stockholders maintain their share of ownership but have more funds to invest in the business. We can expect that investment returns using debt must be higher than the financing charges paid by the business. Because that is the purpose of using debt, invest in projects that yield higher returns over their lifespan.
For tax purposes, interest payments are tax deductible, but dividends are taxable. Therefore, in the long run, debt makes sense since it helps with financial leverage. As stated before, debt should be used with caution. Too much debt can lead to problems because high interest payments affect the business operations and cash flows. For purposes of analyzing the debt structure, we use debt management ratios, which are part of the business’ financial ratios.
Debt ratio = Total liabilities / Total assets
This ratio measures the percentage of assets financed with debt. Total liabilities include current and long-term liabilities. The interpretation of this ratio depends on the point of view; for example, owners prefer a higher ratio since it enhances return on investment. But creditors prefer a lower ratio because it protects from market fluctuations that might affect business adversely.
Times interest earned (TIE) = EBIT / Interest charges
This ratio measures whether the business’ earnings before interest and taxes (EBIT) can cover annual interest costs. Remember too much debt also raises interest payments; therefore, if there are difficulties, creditors might force the business into bankruptcy and/or legal actions.
Debt service coverage ratio = Operating income / total debt payments
This ratio measures the business’s ability to pay the principal and interest of its debt. Debt payments include both principal and interest. A higher coverage ratio is preferable because creditors view the business as less risky.
Conclusion:
Debt ratios measure the financing structure and proportion of the business. As with several other ratios, its usefulness is enhanced when compared with the industry or competitors. Also, comparisons with past years improve these indicators. Keep in mind that ratios aid in making sound decisions relating to increasing debt use or minimizing it.
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