In the economic system that prevails today, there are a large number of instruments and tools to undertake all types of businesses and investments around the world. However, to raise from a small business, to ensure the preservation of an already consolidated company, It is extremely important that we learn to handle some of these instruments perfectly, so that they allow us to ensure the optimal functioning of our company and business.
For people who know about the subject, no one will fail to recommend that we pay special attention to the management of the debt ratio, a knowledge that is essential to carry out any business initiative.
What is the debt ratio?
The debt ratio is one of the most widely used financing ratios today. The reason is that it is one of the instruments that allow obtaining very important information to measure and calibrate the financial health of a company. Basically, the debt ratio allows us to measure financial leverage, that is, the maximum amount of debt that a given company can handle. In a certain way, the financial ratio indicates the external financing that the company has.
To have a best idea of what the debt ratio implies, it must be taken into account that while indebtedness is measured, to put it in a certain way, from the dependence of the company on third parties, the debt ratio is used to specify to what degree or extent the company depends on the various financing entities, such as banking institutions, shareholder groups or even other companies.
Another way to understand this financial concept is from the following explanation.
First you have to take into account what some essential concepts mean, such as: assets, liabilities, or equity.
Assets constitute the total value of everything owned by a company or business partnership; In other words, it is the maximum value that the company can have through the multiple assets and rights it owns, which of course can be converted to money or other equivalent means, which provide liquidity for the company. Liabilities, on the other hand, represent all the external resources that can be obtained through various instances, that is, their financing.
In this way, it can be said that while liabilities comprise assets and financial rights, liabilities are made up of credit obligations, that is, debts and payments that have to be made, either for loans acquired with banking institutions or purchases made. on credit with the various suppliers.
In short, the liability represents everything that the company owes to third parties, such as banks, taxes, salaries, suppliers, etc. Last we have the company's net worth, that, as its name might suggest, it is all the net resources that the company has, putting aside the cost of liabilities, that is, are the assets removing the value of all the debts that have to be paid, for which the net worth of a company is obtained by subtracting the liabilities from the assets. For example, if a company has an asset worth 10 million euros, but its liabilities are accumulated at about two million euros, then it can be inferred that its net worth is 8 million euros.
Once we know some essential definitions around the debt ratio, Later, we can already take into account that in most cases, many companies handle external sources of financing, that is, they use loans and credits when they are in periods of exponential growth or when they handle a great diversification of businesses, for example : to finance investments or cover payments for certain current expenses; reason why they have to rely on debts with various financial institutions, suppliers and other companies.
Thus, the debt ratio can be understood as the difference between external financing and the company's own resources, so that it is possible to know if the debt contracted with the company can be sustained through the resources it has. When it is detected that the company no longer has the means to solve a certain debt, then it opts to leave this financing method behind, to avoid having problems with future payments that have to be made. This is how the debt ratio can be a very useful instrument, which if used in a responsible and disciplined way, serves to avoid financial disasters that can cause the entire disappearance of a company or business.
How is the debt ratio interpreted?
When making use of this financial instrument, we must remember that this tells us how many euros of external financing the company has for each euro of equity you have to meet your various financial obligations. In other words, it indicates the percentage of the total amount of the company's debts, in relation to the resources it has to settle its respective payments.
In this way, if we have a debt ratio of 0.50, this indicates that external resources, that is, financing through loans and credits constitutes 50% of the company's own resources. In other words, if the debt ratio is 0.50, that means that for every 50 euros of external financing, the company has about 100 euros of its own resources.
In practice, the optimal values of the debt ratio They depend a lot on the type of company, the financial ideology that it manages, its size and the total resources it has to face any type of eventuality. However, usually the generally accepted criterion for an optimal debt ratio is between 0.40 and 0.60. In this way, the most recommended by financial specialists is that the debts of the companies represent between 40% and 60% of what the total own resources represent. In this regard, it is considered that an indebtedness ratio greater than 0.60 implies that the company is excessively indebted, while one less than 0.40 implies that the company has too many resources that are not being used properly for possible expansion.
How is the debt ratio obtained?
The debt ratio can be calculated from the sum of all the debts that have been contracted, both in the short term and in the long term. Once you have this data, it is divided by the total liabilities, which is obtained by adding the net worth plus current and non-current liabilities (also known as equity). Subsequently, the result must be multiplied by one hundred, to obtain in this way the percentage of the debt ratio with which the company has. The formula to perform this calculation is the following:
Short and long term debt ratio
Fundamentally, there are two main debt ratio formulas, which are used depending on the timing of the debt that the company has. The first is that of foreign funds or short-term debt (RECP). The other is that of external funds or long-term indebtedness (RELP).
The RECP is a method that is responsible for measuring short-term debts or current liabilities, which are divided by the net worth. On the other hand, the long-term debt ratio is obtained by dividing the debts or current liabilities acquired in the long term, by the net worth.
Usually, the strategy used by many companies is that of long-term external financing, since this modality allows them to face the debt in a longer period of time, and therefore, extend the terms they have in order to generate greater productivity and fulfill without problems with the economic commitments acquired.
Conclusion
Just as we have seen throughout this article, the debt ratio of a company corresponds to an excellent financial instrument, which, when handling it properly and responsibly, can represent an ideal tool for the economic management and financial solvency of a company over time. It also allows us to obtain resources in the form of credits and long-term financial loans, from various financial institutions, to quickly grow those businesses with sufficient potential, and always having the peace of mind that the payments and bills of said debts can be covered. Without any problem, because that is precisely what it is for us to keep track of the debt ratio that our company or business has.
Simply put, it is a method to have control over loans, credits and debts, as resources that can be solved in a certain time, which allows us to develop the business without the obstacle of lack of financing, and having the certainty that all the economic commitments acquired can be covered, without setbacks that may affect the stability or financial health of the company.