Debt is the term used to evaluate the degree of financing of the entity through debts (or, in general, liabilities). Today we will know precisely some debt indicators that you should monitor to take care of the health of your business.
The company can be financed through equity (share capital, share premium, retained earnings) and debt (loans, outstanding liabilities, etc.).
Debt and financial structure indicators control how the company is financed and its ability to cover long-term liabilities.
Risks of debt
A high level of debt is associated with the following risks:
- Lower solvency: the company may not be able to meet its obligations in the future or will have problems obtaining a loan
- High cost of debt (interest), which reduces the profitability of the company and, therefore, also the dividend to shareholders
- The risk of realization of the assets that the bank has as collateral
- The company may not be able to obtain other sources of financing
- Capital increases can put more people in control, which can threaten decision-making flexibility
Examples of debt indicators
These are some debt indicators that you should follow to take care of the performance of your finances:
1. Debt ratio / Debt to asset ratio
The debt ratio (ratio of debt to assets) is one of the indicators of debt and financial structure. Expresses the relationship between debt and total assets. The higher the indicator, the higher the level of debt and the associated risks.
2. Own funds ratio / Own funds to assets ratio
The equity ratio expresses the relationship between equity and total assets. This indicator shows what proportion of the assets will remain for the owners if the company pays all obligations. From the reverse perspective, it can also help evaluate the company’s debt.
3. Debt to equity ratio
The debt/equity ratio is another indicator of debt and financial structure. Expresses the proportion of debt capital with respect to equity. The inverted indicator is the proportion of equity over debt.
Instead of debt capital, only long-term creditors, loans and credits can be used.
The relationship between equity and debt is one of the most important debt indicators. It is an inverse indicator to the relationship between debt over equity, which is the most used.
4. Interest coverage
Interest coverage is one of the indicators that shows how many times earnings before interest and taxes exceed interest expenses, or how many times earnings can be reduced before reaching the limit of interest expenses. Therefore, the higher the indicator, the better.
If the indicator is high, you can expect a high loan repayment capacity and request a new loan.
5. Interest charge
Interest burden is one of the debt indicators and shows what proportion of earnings before interest and taxes is used to cover interest expenses.
It is an inverse indicator of interest coverage, which is used much more in practice.
6. The overcapitalization/undercapitalization indicator
The overcapitalization/undercapitalization indicator is one of the indicators of indebtedness and possibly also liquidity.
The ratio indicates the proportion in which fixed assets are financed with long-term funds. The analysis provides a similar result to that of working capital.
7. Debt repayment period
The debt repayment period is one of the debt indicators that shows, in years, how long the company is expected to repay its loans and borrowings from operating cash flow.