Working with third party capital to drive a company’s growth is a common practice, but when mismanaged it can lead to management problems. To avoid this, it is important to keep a constant eye on the debt ratio and make sure that the financial commitment is acceptable.
Most entrepreneurs even know the full amount of their debt with financing and suppliers, but this number has no tangible significance as it does not show how much of the venture’s capital is committed. The total debt value is just one of the financial indicators to be evaluated, as is the index.
We have prepared this indicator to answer your questions regarding this important business indicator. Continue reading!
Know the debt ratio
Is it possible to differentiate how much of the company’s activity uses third party capital and how much is financed by personal capital? That’s where the debt ratio comes in! When explored in a historical series, it reveals the fraction of external resources that the venture has used to guide the business and provides essential information for decision making.
The debt ratio is widely used by companies to discern the extent of assets the business has but which are funded by third party resources, ie debt that must be settled at a later date.
Know if the debt ratio is worrying or not
Essentially, a company’s debt ratio is an indicator of financial performance that aims to show whether the business needs to be in debt to continue operating.
The company’s degree of indebtedness considers several successive periods to indicate how the venture has been doing to earn revenue. For example, he wonders whether the firm needs to resort to nearby capital to inject it into its production method or whether it needs to acquire debt as loans to repay other liabilities.
The first case may be pointed to as a good level of indebtedness, since the company is borrowing from itself. However, in the second case, there is a great possibility that the business will go bankrupt, so be very careful.
Learn how to calculate the debt ratio
To do this, one does not have to have specific skills let alone pay to get it. The index is a simple account whose basic numbers can easily be found on the balance sheet. Check out how to make this account uncomplicated and efficient:
With the balance in hand, find the values of current and noncurrent liabilities. They show the amount of third party capital being used in the company in the short and long term, respectively. Keep in mind also the value of the total asset.
The debt ratio is the result of dividing the sum of liabilities by asset. To get the percentage, simply multiply this number by one hundred, as follows:
IE = (CURRENT LIABILITIES + NON-CURRENT LIABILITIES) / (TOTAL ASSETS) X 100
With this formula, you get the percentage value of your company debt. Obviously, the bigger it is, the worse the financial situation you are in. However, there is no default value indicating a healthy debt ratio. Generally, starting at 70%, the dependence on third party capital is excessive.
Interpret the data obtained
An interesting thing about financial ratios is their ability to indicate paths and solutions. With the debt ratio is no different.
Even if the value is high, it is only a worrying number if the company’s commitment is made to cover other debts and obligations, causing the so-called snowball. Otherwise, the percentage may indicate that new investments are being made to drive growth.
Even the interest on bank financing can be negligible given the increase in revenues resulting from the expansion of the venture. That is, if your business is in this scenario, there is nothing to worry about.
When indebtedness is caused by a large number of obligations, you need to review costs and perhaps renegotiate debt to improve working capital and even analyze your balance sheet and income statement to find exactly what is hindering your performance. Company
That way you are most likely to reduce the amount of third party capital in your business, gain strength in your asset and be able to improve your financial decision-making power, relying less on loans to keep your business strong and thriving.
Assess the business situation
To classify whether a company’s debt ratios are at acceptable levels, it is not enough simply to have present value. It is necessary to follow the historical progress of the values and to follow this in monthly, quarterly and annual support. Thus, the longer the time, the greater the assimilation of the manager.
It is also significant to make certain comparisons. Is 25% good value or bad? This will depend on the market in which a certain company is inserted. If all competitors have rates around 12% or 18%, definitely 25% is a high value. By contrast, if they have values greater than 35%, then 25% is a good value.
These amounts of competitors will rarely be directly available to companies, as this is strategic and confidential enterprise data. However, there are ways to find out an industry’s average debt ratios through information from unions, boards, or associations that represent a particular activity.
The debt ratio is one of the tools for a manager to be able to optimize a company’s financial health, but it is not the only one. A bad index does not mean the end of everything, as it must be ascertained with a set of other variants. Similarly, a good debt ratio alone does not portray reason to celebrate.
Once the calculation is made, it is time to use the information obtained in favor of the company. With the help of specific tools, it is worth analyzing which action plans can be established. So it is always wise to have a specialist firm to help you understand, for example, how high interest rates on loans and financing are interfering with business results.
Using technical help is highly recommended as it has strategic value for making decisions and maintaining the financial health of a company.