Debt ratios can be used to know the financial health of companies, governments, and individuals. Lenders and investors may calculate the debt ratio of a company to know the extent to which their investments could be at risk. These ratios can also determine how easy or difficult it is for a company to pay loans given to them. The debt ratio is obtained by dividing the total liabilities of a company by its assets. If it’s high, then the degree of debt financing of that company is also high.
To know what a good debt ratio is, you need to learn more about it. This article gives you the essential things that you need to know about debt ratios.
Types Of Debt Ratios
There are primarily four types of debt ratios, namely:
- Debt To Equity Ratio
This ratio is found by dividing the total debt by the total equity amount. This ratio aims at determining whether the funding is from a good proportion of the debt. Lenders like to use this ratio to decide if they can get a significant equity stake in a company.
- Debt Service Coverage Ratio
This ratio is found when the total yearly operating income is divided by the annual debt payments. From this ratio, a lender can know the business’s ability to pay both the principal and interest of its loan.
- Debt Ratio
This is determined by dividing the total debt of a company by its total assets. Higher ratios indicate that the company’s assets are being funded through debt rather than equity. This approach of financing is considered riskier by lenders and investors.
- Interest Coverage Ratio
This ratio is determined by dividing net earnings by interest expense. This ratio aims to find out if a company can pay for its interests when they’re due, especially if it can’t afford to pay the loan balance. This ratio is used when loans are expected to be rolled into new loans when they attain maturity.
When calculating these measurements, it’s vital to use a trend line. This will help you know if a company’s debt loan is increasing over time or if its ability to pay the loan decreases. These ratios may be necessary when a firm requires a credit rating agency to rate one of its debt securities. If the proportions are high, the rating agency is likely to give a low rating, increasing the number of interests for securities to be sold.
Interpreting The Debt To Total Assets Ratio
This comparison is shown in decimal formats and ranges from 0.000 to 1.000. A 0.5 ratio shows that half of a company’s total assets are funded by liabilities. That means that 50% of the assets are debts. If the lower value is less, that’s a signal of a stable company with a low amount of debt. On the other hand, a higher ratio means that a good percentage of the company’s assets can be claimed at any time by its lenders. It also means that investors who intend to undertake projects with the company are risking. That’s why most businesses with a higher debt to asset ratio look for equity financing.
Improve Your Debt To Total Asset Ratio
A high debt to total asset ratio isn’t a good sign for your company. That’s why it needs to lower its debt to reduce the ratio. But there are options it can follow to increase the debt to total asset ratio. These include:
* Adding New Shares
When a company adds its shares, it improves its cash flow. This additional money can be used to pay the existing debt and significantly reduce the burden. This way, the debt reduction will minimize the debt to total asset ratio.
* Leasing Assets
Your company can also add some cash flow to pay off debts by selling its assets and then leasing them back.
* Equity Swap
Your company can receive a debt swap if its lender makes it an equity shareholder. This will eliminate the debt you owe the company and, in turn, increase the ratio. You can also plan for convertible debentures.
* Focus On Increasing Sales
If your company can increase its sales without increasing overhead expenses, it’ll minimize debt and enhance the debt to total asset ratio.
Benefits Of Debt Ratio
- Giving Important Information About Financial Leverages
Your company’s debt ratio can help investors and your company’s shareholders understand your financial situation deeply. This, in turn, can help them make informed decisions about investing in your company or not.
- Easily Understood By Shareholders And Investors
The debt ratio calculation is easy to understand, enabling even shareholders and investors who don’t know anything about finances to decide your company. Because the formula is straight forward, it can also help financial analysts calculate and analyze the ratio quickly.
- You Can Use It To Make Comparison
Debt ratio allows shareholders and investors to compare your company’s results with other companies of the same size and capital.
Disadvantages Of Debt Ratios
- It Focusses More On The Past Performance
The information given by the debt ratios to shareholders and investors is about the past performance of a company that may not give an accurate picture of the company’s future. The fact that a company is facing a financial crisis doesn’t mean it’ll face it forever. The financial difficulty may be a result of the current circumstances surrounding the business.
- It Can Be Manipulated Through Accounting Treatment And Policies
Accountants can manipulate the debt ratio data to develop better financial debtors that can attract shareholders and investors.
- It Only Focusses On The Financial Perspective
The debt ratio only measures a company’s financial ability through financial data. However, to make better decisions, lenders and investors need to include non-financial data to know the company’s position accurately.
How The Debt To Equity Ratio Is Used To Evaluate The Capital Structure
- Loan Acquisition
Bankers and investors use this ratio when determining the amount of money to loan a company. That’s because it shows how the company is transacting its businesses. This information is vital for investors and lenders because it’ll help them to know whether their money will be put to good use and bring a return. If your company’s D/E is high, lenders may refrain from loaning it because of the significant risk involved. Bankers also use this ratio with other factors such as probability figures, revenue, and cash flow, to compare your company’s performance with that of other companies within the same industry.
- Determining The Competition
Your company can know how its debt to equity ratio compares with other companies within the same industry. As you make changes in the company or when the markets fluctuate, your managers need to know where your company is in relation to other companies. This will help them to understand where your company stands with others in the industry. It will also enable them to know whether it’s advisable to take more debts, invest in new projects, or wait for changes in the market.
- Understanding The Effects Old Debt To Equity Ratio
Through D/E, your company can know how its daily activities and decisions affect its debt ratio. This knowledge is vital because it influences other financial aspects of the company. How you manage the amount of cash that flows into your account can also impact the debt to ratio number, further impacting how shareholders and investors regard its capital structure.
The debt ratio and its various types are important factors that investors and shareholders consider before investing or giving a company loan. No investor would loan a company that has a huge debt because the risks involved are high. Therefore, a company needs to have a lower debt ratio for it to attract investors.