Debt management ratios are used to manage a company’s ability to continue to operate without encountering financial challenges in the future. These ratios are sometimes referred to as a long-term solvency ratio. Lenders, investors and business owners rely on this ratio as a decision-making tool and use it to measure the overall health of their business.
How are debt management ratios used?
Debt management ratios are used to determine whether or not a person is capable of handling long term debt in addition to regular obligations. The measurement of a company’s total debt amount in proportion to what is financed is considered the debt management ratio. These metrics can be used in gauging the overall health when operations, savings, funds and stocks are all taken into account. This ratio is very important in determining the level of risk associated in dealing with a business. This proportion also weighs the potential of default. The ratio measures the proportion of a firm’s assets funded by equity or debt.
What happens if the debt management ratio is unfavorable?
If the debt management ratio is unfavorable, the business is at risk of default, bankruptcy or some other form of financial distress. Industries that are unpredictable when it comes to sales and cash flow do not have the same latitude as their more stable counterparts. These differences determine how a business is able to handle its debt. Companies classified as being capital-intensive require more capital like plants to operate; low capital industries do not. This is why companies that are capital-intensive tend to have higher debt management ratios compared to companies that have low-capital. A company with a higher ratio can expect to pay more in interest rates in the debt management ratio isn’t low enough.
Why are they used?
This ratio is used by lenders and investors to measure the health of a business. High debt-to-equity signals that a company may be headed in the wrong direction or may be approaching financial distress. The revenue generated isn’t substantial enough to meet all obligations. These ratios may also demonstrate the company’s inability to really increase their profits and properly leverage them to the firm’s advantage. Investors like to know beforehand whether or not it makes sense to invest in a particular business.
How do lenders treat those with better debt management ratios?
Companies with better debt management ratios are much more likely to secure funding from lenders and investors. Those with the best debt management ratios are in a better position to acquire capital if more is needed. Other businesses may have a more difficult time getting additional capital if they get in a bind.
Debt management ratios can be a valuable tool in assessing the health of your business and gauging its long term solvency. It can also helpful you strategize on how to better leverage your finances should you discover a need for loans and investors in the future.
If you have questions or concerns related to debt management ratios or services contact the professionals at Rescue One Financial, we are here to help!