How To Determine The Debt Position Of A Company

It is normal for businesses to take loans to finance their operations. However, their ability to repay those loans or otherwise, can affect you as in investor. These ratios should serve as guide for you

It is not uncommon to find many people who fund their lifestyles with borrowed funds. From taking loans to get cars, buying houses on borrowed money, and even those who simply can’t afford to be constrained by the limited interests of the broke community.

The truth is, nobody really cares how you get your money or how you spend it. Not unless they’re vested in it.

In finance, leverage or gearing refer to the proportion of a company's debt to the value of its ordinary shares or equity investment. In other words, it seeks to compare the benefits derived from using the loan, the challenges that come with it, and the ability of the company to pay back in due time.

Certain ratios are computed in determining the debt position of the company and these ratios indicate of how the company’s assets and business operations are financed. When a company is said to be highly leveraged, it means that the company is in too much debt and might pose a risk when it is time to repay the loan.

As an investor, being a part of a company that is highly leveraged poses a risk to your investment. An example of this is how , in Nigeria, Asset Management Company of Nigeria (AMCON) seized possession of companies who have defaulted in repaying their loans.

In order for you not to be caught unawares as an investor, the following ratios will guide you in determine the debt of a company and its ability to repay.

Debt Ratio

The Debt Ratio is probably the easiest way to determine the leverage of a company. The debt ratio simply shows how well a company can repay its liabilities with its available assets. Put differently, the debt ratio tells us what percentage of the total assets are owed in loans in proportion.

To calculate the debt ratio, total liabilities is divided by total assets. When computing this ratio, it is particularly important to take the industry into consideration. For some industries, 30% is fine and for others the proportion needs to be higher.

Debt-to-Equity Ratio

The debt-to-equity ratio simply shows the percentage of the financing capital that is derived from banks or shareholders. It compares how much money is gotten from debt and how much is derived from equity.

To calculate the debt-to-equity ratio, simply divide your total liabilities by total equity.

Debt-to-Assets Ratio

Also related to the debt-to-equity ratio, this ratio shows you the percentage of a company's total assets that were financed through debt or by creditors. To compute this, the total value of a company's liabilities is divided by the total amount of the company's assets.

Interest coverage ratio

Interest is a big part of taking loans. Therefore, it is also important to measure their impact. The interest coverage ratio is used to determine how easily a company can pay interest on its outstanding debt. To compute this, divide total Earnings Before Interest and Tax (EBIT) by the company's interest expense.

It is important to remember that computing these ratios are not enough. Review the past trends of the company and compare with industry benchmarks for optimal analysis.

Written by Lawretta Egba