While it is true an important goal that we have been taught is to reduce our indebtedness, there are many companies or people who at some point have had or will have to lend money to be able to acquire certain equipment, vehicles, to buy a house or perhaps to meet payment commitments at a time of low cash flow. What then are the challenges of this?
We must understand that getting a credit for yourself is not harmful
Strictly speaking in sound financial theory, incorporating a certain level of debt improves the profitability of the investor (this is called financial leverage). The problematic really is when our indebtedness is excessive and goes beyond our capacity. Precisely then, defining our capacity is a primary task in order to determine the sustainable level for our business.
The sustainability of our company can be impacted by a high level of debt in different ways. First, high indebtedness will demand higher interest payments, which will reduce the profits of our business. Second, by increasing the level of debt, the interest rate will be higher as a result of a decrease in our rating by increasing the risk to financial institutions, so it will also impact profitability. Finally, if the company begins to fail in its financial commitments this is very damaging, since it could cause until a closing of operations.
To measure our indebtedness
we can make use of two fundamental financial reasons. The debt ratio is defined as the proportion of our assets (remember our assets: inventories, warehouses, trucks, etc.) that is financed with third party money (this is what Accounting is known as liabilities). Suppose that the assets we own have a total value of $ 10,000 and that of that total we finance $ 6,000 with a loan, our debt ratio would be 60 percent, (6,000 / 10,000). A higher percentage indicates greater indebtedness and a value close to 100 percent would be very risky and it would be difficult for them to give us additional financing with that level.
The second indicator is the interest coverage ratio. This is defined as the number of times our earnings can pay the interest expense of the loan fee. Consider at one time a business that has an operating profit (that is before paying interest and taxes) of 2,000 dollars and must pay interest for 1,000 dollars the interest coverage would be two (2,000 / 1,000) which means that with the profit that we generate in that business we can pay the interest of the loan twice.
This indicator is one of the most used to determine the payment capacity of companies, since greater interest coverage implies a better credit rating, but a lower value than one in this indicator would reflect that we have no capacity to pay interest that we owe for the loan, which would increase our risk and decrease our rating.
An excessive level of debt harms us
It properly managing our level of indebtedness and enhancing our interest coverage can help us achieve better financing conditions. Remember that to become an AAA client you must learn to measure and manage your level of indebtedness, do not forget this in your next financing decision.