How to assess a company’s debt? The debt indices allow us to analyze the financial structure of a company. We use these indices to know the amount of debt that a company has and the relationship between that debt and other financial quantities (Assets, Benefits, etc.), so we can predict financial risks and difficulties in meeting interest payments and even assess whether a company has too high a debt level to invest in it.
Next, we will focus on some of the main indexes to assess indebtedness. Neither is better than the other, nor may they all need to be taken into account, but they all provide information about a company’s level of indebtedness. Depending on the sector to which a company belongs, a figure in one proportion or another may be considered excessive or not, so the sector to which a company belongs must always be taken into account when analyzing debt ratios.
Assess a company’s debt
Debt to Equity
It measures the relationship between capital contributed by creditors (debt = debt) and that contributed by shareholders (capital = quity).
Debt to Equity = Net Financial Debt / Equity
It is a quick tool that indicates the financial leverage used by a company; that is, it provides an idea of how much it uses debt to finance its operations.
- A ratio of 1.0 means that a company finances its projects with a balanced combination of debt and equity.
- A high debt ratio (> 2.00) of debt to equity is worrying, as it can indicate dangerous amounts of leverage.
- A small proportion (<0.3) may indicate that there is a conservative management that is not willing to take risks.
Debt to Assets
This index measures the company’s ability to generate sufficient resources to deal with the company’s debt.
Interest coverage = Operating Income / Financial Expenses
The higher positive values we obtain from this relationship, the greater the company’s ability to face the cost of interest.
Solvency measures a company’s ability to meet its payment obligations. This indicator expresses that part of the debt is guaranteed with its own assets, although this does not guarantee that the creditor will charge at the indicated time, as liquidity problems may arise.
Solvency = Total Assets / Total Liabilities
The company needs a minimum level of inventory to be able to carry out its activity. For that, we use the acid ratio that indicates the immediate liquidity of a company , that is, it is an indicator that shows us the level of short-term liquidity that a company has.
Acid Ratio = (Current Assets – Stocks) / Current Liabilities
If the acidity test were less than one, it would indicate an excessively high current liability in relation to the asset, and it would be advisable to sell shares to better deal with short-term debt.
This index is used to see if the company is able to handle its short-term debt. The value of this proportion must be greater than 1.2. A lower value implies liquidity problems and a much higher value of underutilization of resources. The best currently shows the same information as the Working Capital.
Current Ratio = current assets / current liabilities
In general terms, we will consider an index greater than 1 to be healthy, as it would indicate that current assets allow us to deal with short-term debt.
Financial capacity to pay
It measures the company’s ability to deal with its financial debt based on the generation of EBITDA (earnings before interest, taxes, depreciation and amortization). It can be measured both in relation to total financial debt and net financial debt.
Financial payment capacity = Net Financial Debt / EBITDA
It is a relationship that shows the financial health of the company. The lower the ratio, the less problems the company will have to pay the debt
- If the index is less than 2 , it is in the presence of a company with good capacity to pay debts.
- If it exceeds 4, the company may face a financial problem.