Business debt is a big deal for companies,and when it comes to analyzing the performance of a company, there are various factors that must be considered. These include examining the assets and liabilities of the company to gauge its financial performance and debts. Every business requires funds at some point in time for growth or to cover operational expenses. Debt and equity are the ways through which companies can raise additional capital. However, an increased amount of debt can land you in huge trouble. You can seek help from a debt management company to get a solution to your debt problems. You can get in touch with Best Debt Management Agency In London
While you don’t have to pay any interest when you raise funds through equity, issuing shares is a complicated and time-consuming process. In this blog post, we will explore different ways to examine a company’s debt management ability.
Significance of analyzing debts
The ratio of debts can be more as compared to assets. However, this is not a problem as long as a company is able to handle its liabilities. On the other hand, debt includes interests. The higher the debt or longer the period, the more will be the interest payment.
Financial ratios for debt analysis
Here we will discuss some debt management strategies to help you effectively manage your debt.
1. Interest coverage ratio
The foremost thing you need to do is, check whether the operating profits cover the interest charges. In other words, to examine whether the company is able to pay interest on its debt.
You can use the following formula to calculate the Interest coverage ratio.
Interest coverage ratio: EBIT/Interest expenses
If the ICR is below 1, there are high chances of default. On the other hand, If ICR is high, it indicates that the company’s financial health is good and it is not taking further debt with the objective of maximizing its earnings.
2. Fixed charge coverage
Besides interest on debt, the company has various other costs like leases. Examining whether a company can pay its fixed costs is vital if the fixed charges are more than interest payments.
Fixed charge coverage: (EBIT+ Fixed charges before tax)/ (Interest expenses+ Fixed charges before tax).
3. Debt ratio
One of the best ways to know whether a company may default on its debt payments is by analyzing the debt ratio. Prior to making an investment in any company, it’s good to check if the company has the ability to manage its liabilities or not. If the debt ratio of the company is more than one, it indicates that the company has more debts than assets.
Debt Ratio: Total liabilities/Total Assets
4. Debt to equity ratio
It’s also essential to analyze the company’s debt-to-equity ratio. An increasing Debt to equity ratio indicates that the company is not earning enough to continue its operations. The ratio can be calculated using the following formula:
Debt to equity ratio: Total liabilities/Stockholder’s equity
While examining the Debt Equity Ratio, you must also consider the ICR.
- A high debt-equity ratio and a low ICR signify that the company is relying entirely on debts to continue its business operations.
- A high debt-equity ratio and a high ICR signify that the company is utilizing additional debts to maximize its profitability.
- If the debt-equity ratio is low, there are fewer chances of default.
5. Debt To Tangible net worth ratio
If the company gets sold to an investor who is preparing to sell the assets of the company or is no longer willing to carry on the business, he would like to know the worth of the assets owned by the company. Debt to tangible net ratio will help you know whether the company will be able to pay off the debts after selling the physical assets or not.
The formula to calculate the debt to tangible net worth ratio is:
Debt to tangible net worth ratio: Total liabilities/ (Stockholder’s equity-Intangible assets)
If the ratio is above, it means that the company cannot settle its debts after selling the assets. On the other hand, if the ratio is below 1, the company can settle its debts after liquidating the physical assets and will have some balance thereafter.