Why Debt Ratios Matter

If you don’t have a handle on your company’s debt you may find yourself without a company. Here are a few things to consider.

Types of Debt

There are two sources of capitalization for a company. One is owner equity and the other is debt. First let’s consider debt.

Debt may be in a number of forms, with bank loans to bonds being among them. An asset-based loan could be from a bank or other financing organization and is generally secured with the backing of such assets as equipment, accounts receivable, and inventory. These loans could be for a line of credit or for the actual purchase of the equipment. Another form of a loan is through factoring of receivables. Bonds are generally issued to finance long-term growth. Although many people don’t think about it, accounts payable is also a form of debt. This is not meant as a comprehensive list of the kinds of debt, but merely to give you an idea of how a company may take on debt.

Owner equity is the interest that owners have in a business. It includes the par value of common stock, additional paid-in capital in excess of par, and cumulative retained earnings less any dividends paid. Additionally, treasury stock reduces the amount of owner equity.

All that said, we now turn to some ways to evaluate the impact of debt on a company.

Debt-to-Equity Ratio

The debt-to-equity ratio measures the balance between assets owned and asset owed. The formula is:

Debt-to-Equity = Total Liabilities / Total Equity

If you were considering loaning to a company you would most likely want to see this ratio relatively low, indicating that the company is able to internally finance much of its operations and growth. You would not want your loan to dramatically skew the debt-to-equity ratio. On the other hand, investors (owners) often prefer this ratio to be high, indicating that leverage is being maximized to grow a company. Unfortunately, owners can get carried away with leverage and find themselves in trouble. The troubles revolve around the ability to service the debt in the form of interest and debt payments. I’ll be talking about those in the future.

In the meantime, are you comfortable with the level of debt your company carries, or do you find yourself wondering, “How did we ever get in so much debt?” or “How will we ever get out from under this mountain of debt?” Both those questions may be clear indicators that your debt is out of control and your owner equity is insufficient.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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