Most companies, in addition to their own capital, rely on external funding to operate their business. However, it is crucial to monitor loan evolution using debt indicators to prevent future issues.
Utilizing third-party capital to expand production or open new branches is a useful initiative. However, when debt reaches a certain limit, the company struggles to meet its obligations.
This can even affect the well-being of executives. According to a recent Serasa survey, 88% of Brazilians have experienced shame due to debt, and 85% have difficulty sleeping when in debt.
To avoid this, a company’s financial department must assess the extent to which leverage is beneficial and how it impacts profit statements.
The best approach is to consistently track debt indicators. If you are looking to better understand these indicators, you are in the right place. Keep reading!
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Debt indicators are numerical measures that reveal the level of an organization’s indebtedness, indicating whether the debt is at a secure or risky level.
As we mentioned earlier, it is common for businesses to borrow money from third parties to fund their operations, which can include:
Banks and investors lend money to organizations with the expectation of earning a return on their investment. On their part, suppliers extend credit terms for payment, which acts as a form of lending.
To effectively monitor debt indicators and other financial metrics, it is important to have systems for analyzing indicators and results.
This enables the sale and fosters long-term commercial partnerships without the imposition of interest charges, thereby having a lesser impact on the company’s costs.
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Debt indicators serve to inform business owners and administrators whether the debt owed to third parties is at a safe level or heading into riskier territory.
Through these indicators, organizations can make decisions about expanding production or cutting costs to avoid future issues with suppliers, banks, and investors.
High levels of indebtedness can lead to insolvency, resulting in increased financial costs and even long-term bankruptcy.
It is worth noting that debt, also known as leverage, is healthy up to a certain point, as it offers the opportunity for a company to grow in the market and enhance return on equity.
However, uncontrolled and unmonitored debt growth can ultimately lead an organization to ruin, a scenario witnessed over the years. This underscores the crucial importance of sound financial planning.
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In essence, a company can incur debt from third parties, such as suppliers, banks, and investors, in two primary ways:
Essentially, long-term debt places less strain on a company’s cash flow compared to short-term debt. Examples of long-term debt include:
Examples of short-term debt encompass
Given its potential harm to the company, short-term debt should generally be avoided, except for supplier credit terms, which do not accrue interest when paid promptly.
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Now that we have discussed what debt indicators are and their significance for an organization, let’s delve deeper into the 6 most commonly used ones:
This indicator reveals the proportion of the organization’s resources originating from third-party capital, helping assess the company’s debt level. The formula for D/E is as follows:
Here, current liabilities represent short-term debt, long-term liabilities indicate long-term debt, and shareholder equity stands for the company’s own capital.
The higher theD/E, the greater the company’s debt level, implying increased vulnerability to market uncertainties. When D/E exceeds 1, the company becomes insolvent.
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The debt composition indicator reveals how much of the company’s debt is concentrated in the short term. The higher this concentration, the more challenging it can be for the company to meet its obligations.
Conversely, the lower the concentration of short-term debt, the healthier the company’s cash flow, providing more time to respond to market turbulence. The formula for this debt indicator is as follows:
In this context, the higher the DC, the more concentrated the company’s short-term debt, and the greater the risk of insolvency.
It is worth noting that factoring of receivables, which involves bringing forward the receipt of invoices with 30, 60, and 90-day maturities by paying interest, can be extremely costly for the company, and it should be used sparingly.
This indicator provides insight into the structure of a company’s capital. When a company excessively immobilizes its equity, fewer internal resources become available.
In this situation, the company becomes more reliant on third-party capital to finance its current assets, typically composed of:
To determine the degree of Fixed Asset Imprisonment, apply the following formula:
FAI = Fixed Assets / Shareholder Equity
Fixed assets refer to the company’s permanent assets, such as machinery, vehicles, real estate, and land. In this context, the higher the FAI, the greater the capital immobilized in relation to shareholder equity.
In other words, as FAI increases, so does the risk of insolvency. It is important not to confuse the growth of FAI with the growth of fixed capital alone.
When fixed capital grows in proportion to shareholder equity, FAI remains stable, and the company doesn’t become less solvent.
However, when fixed capital grows while shareholder equity remains constant, FAI increases, indicating that the company is shifting capital from current assets to fixed assets, thereby increasing the risk of insolvency.
Another debt indicator is LTRI, which reveals how much of the company’s long-term resources and equity are invested in its fixed capital.
This indicator also provides insights into the company’s capital structure, helping understand the extent of investment in fixed assets relative to long-term debt and equity.
To calculate the long-term resources immobilization, use the following formula:
A higher value for this indicator increases the likelihood of the company encountering difficulties in meeting its obligations.
It is important to note that, for didactic purposes, it is ideal for fixed assets to be equal to or less than long-term liabilities. This indicates that these assets are financed with long-term debt and are not depleting the company’s equity.
When fixed assets exceed long-term liabilities, they are not only financed by long-term debt but also by the company’s equity, which could otherwise be allocated to current assets to ensure greater payment liquidity.
The General Indebtedness Ratio is one of the most basic debt indicators for a company, representing the proportion of debt in relation to the total assets of the business. It essentially reflects the organization’s level of leverage. A higher value for this indicator indicates a more indebted company.
However, it should be considered alongside the previous indicators, especially the DC, as by itself, it may suggest a reasonable level of indebtedness, but the debt could be concentrated in the short term, adversely affecting the company’s liquidity.
The formula for calculating it is as follows:
There is not an exact value to determine what constitutes a good level of indebtedness for GI, as it depends on the debt structure. However, when it surpasses 100%, the company faces the risk of insolvency.
For GI to have a healthy level of leverage, third-party capital should be less than the total assets of the organization.
The financial indebtedness ratio represents the relationship between the amount a company owes to third parties and the amount invested by shareholders, with its formula being:
The key distinction between financial indebtedness and general indebtedness is that it evaluates the debt in relation to shareholder equity, which is the company’s own capital.
Conversely, general indebtedness represents the percentage of debt concerning all assets acquired by the company, both with its own and third-party capital.
In this context, when GI exceeds 100%, it is more concerning than when FI surpasses 100%, although both scenarios are not advisable.
In general, a higher FI indicates more debt relative to the company’s equity, making it more leveraged. In times of market turbulence, a high degree of leverage can lead the company towards insolvency.
To calculate debt indicators, the company must have a developed balance sheet. In other words, all the accounts mentioned in the formulas are derived from the company’s balance sheet.
The accounting department is responsible for preparing this balance sheet and the income statement, which shows the organization’s net profit. Through an inventory, the accounting department records all of the company’s assets, which can include:
These assets are classified as current when they enter and leave the company more frequently, such as inventory, accounts receivable, and cash, or as fixed when they remain on the balance sheet for a longer period, such as machinery, vehicles, and real estate.
The accounting department also compiles the company’s liabilities, which can include:
The difference between assets and liabilities results in shareholder equity, which should be on the liability side of the balance sheet since it represents the company’s equity that also finances its assets.
The sum of assets should always equal the sum of liabilities when considering shareholder equity. With this data in hand, simply plug the values into the formulas to find the debt indicators.
Strategic planning is essential to manage high levels of indebtedness. To assist you, we have prepared a list of the best strategic planning tools.
The analysis of debt indicators should be conducted as outlined in the article. In other words, the higher these indicators are, the greater the risks of the company becoming insolvent.
It is worth noting that one indicator complements the other, so all of them should be considered, and a combined analysis allows the organization to make more informed decisions.
In this regard, when a company observes excessive growth in one indicator, it needs to identify why it is increasing and make decisions to reverse the situation. This could include increasing the company’s equity on its balance sheet.
One of the best ways to collect data, generate indicators, and monitor them is through specialized software. Using such software prevents manual work, saves time, and reduces the risk of errors.
When it comes to cutting-edge software for analyzing debt indicators, one that stands out in the market is STRATWs One.
With it, you can track the indicators and make decisions to improve the company’s financial health more rapidly. Explore our solution here:
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