There are many financial reports businesses produce and calculations they make to help inform their decision-making process. Financial expert and CEO of Everest Business Funding Scott Crockett says examples of these calculations include long-term debt ratios.
These formulas allow managers to quickly calculate the company’s ability to handle long-term debts while they’re figuring out whether to make certain investments. Understanding what these ratios are and how to use them is essential for success.
Below is an explanation of the different types of long-term debt ratios.
Wat is a Long-Term Debt Ratio?
A long-term debt ratio is a calculation businesses can use to estimate the capacity the company has to meet long-term loans. It is sometimes referred to as the long-term-debt-to-total-assets ratio.
In most cases, this calculation is completed on an annual basis to align with the release of the business’s balance sheet. This allows a company to calculate its year-over-year results of the ratio to determine trends in leverage.
If that ratio were to rise throughout the year, then it would signify that the company is starting to depend more on debt. The reverse would tell the opposite story.
Debt to Assets
One type of long-term debt ratio is the debt-to-asset ratio. This shows what percentage of the business’ assets are being financed by an outside creditor. High ratios would indicate that the company is very dependent on debt to finance its operations, which in turn could be a potential sign that the company is in a weak financial position.
This ratio is typically used to determine whether the company could raise additional cash by taking on new debt. The calculation is completed by dividing the total debt for the business by the total assets.
Debt Service Coverage
A second example of a long-term debt ratio is called the debt service coverage ratio. This calculation measures the ability of a business to make its scheduled debt payments when they are due.
To calculate this ratio, you will take the business’ EBITDA — or earnings before interest, taxes, depreciation, and amortization — divided by all debt principal and interest payments.
This ratio will show the amount of cash your business generates for each dollar of the debt principal plus interest that it owes. Ideally, this ratio should fall above two. This would indicate that your company’s EBITDA would be able to cover the total amount of your debt liabilities twice.
Debt to Equity
Scott Crockett says that a third long-term debt ratio is the debt-to-equity ratio. This ratio is the simplest of the three to calculate. Just divide the company’s total liabilities by the total of all shareholders’ equity.
Banks and financial institutions often examine this ratio when evaluating whether to extend a company’s new credit. That’s because it’s a good indicator of whether a company is able to not only meet current debt commitments but also whether it’ll be able to get new cash by obtaining new debt if it must do so.
A higher debt-to-equity ratio indicates that a company is highly-leveraged. These companies would be riskier to lenders because they have a higher likelihood of missing a debt payment if their revenues were to decline.
Most lenders will want to see a debt-to-equity ratio that isn’t greater than 2:1, though some may want it even lower.
About Scott Crockett
Scott Crockett is the founder and CEO of Everest Business Funding. He is a seasoned professional with 20 years of experience in the finance industry. Mr. Crockett’s track record includes raising more than $250 million in capital and creating thousands of jobs. Scott has founded, built, and managed several finance companies in the consumer and commercial finance sectors.