Anyone who controls a company or manages the financial branch of an enterprise should be very attentive to its debt level. This indicator shows much about a company’s current financial state and the budget that the company will have.
However, to know whether a business is in debt or not, it is not that easy. For you to be able to imagine this scenario, do understand what debt is, the risks of such, and the financial signs about the subject.
Want to know how to analyze your business debt and 3 signs that your business is in debt? Check out this complete content!
What does debt mean for a company?
Before learning about the signs of a company’s debt, you have to learn what this situation represents. Although this may seem a simple concept, it is actually common to confuse debt with default, which might lead to some financial problems.
A debt is a commitment or liability undertaken by an enterprise. Hence, it deals with a credit relationship: one party is the creditor party-the party who is entitled to receive the amounts-and the other party is the debtor party-the party who is obliged to pay the amount.
Now, the credit relationship is a situation in which there is a debt for the debtor party. Therefore, indebtedness refers to situations in which one party assumes a financial obligation.
Debt may seem something to worry about; it actually isn’t at all. After all, it is a really common situation: all firms pay their creditors bills.
Therefore, it is an index present in practically all businesses. However, it is necessary to be aware of situations in which the level of debt is very high: in these cases, default may occur. This occurs when the company does not pay its obligations within the agreed deadline.
What are the risks of having a high debt ratio in the business?
You have noticed that a high level of debt in the company can lead to default. This scenario results in the payment of interest on arrears and late payment fines.
In practice, this can lead to a snowball effect. After all, the higher the amount of default, the higher all financial obligations become.
Therefore, high debt should be a warning sign for the business. If the company does not have the financial means to meet all the obligations that are due, there will be serious problems.
However, even when debt does not lead to default, it can bring other worrying consequences.
In such a case, the profitability of the company decreases as well when the indicator is too high. After all, part of the revenue of the business will be used to pay off debts. Imagine that your company had revenue of R$50,000 in a quarter. However, debts amount to R$30,000. In this case, the financial surplus was only R$20,000.
On the contrary, the more debt, the smaller the profit share from the gross revenue your business generates. Thus, one should track this indicator and be able to observe signs of debt for good control over finances and results of the operation.
3 Signs of debt to watch out for in your company
As you have seen, a high level of debt can have negative consequences for your company. Therefore, it is worth paying attention to the signs that this indicator may be out of control.
Check out 3 ways to observe this situation in your business below:
1. High EG index
First, it is important that you monitor debt indicators. Among the main ones is the EG index — an acronym for general debt.
Its purpose is to demonstrate the proportion of the company’s assets financed by third parties. In other words, among all the assets, which ones lead to debt, considering that there is a credit relationship.
To arrive at this index result, the company must have some information at hand. One of them is the total assets of the business, adding up all cash, inventory, machinery, investments, etc.
The other relevant information is third-party capital. In other words, assets related to business partners. Among the most common are loans , financing and other lines of credit contracted.
Once you have this information, simply apply the following formula:
EG Index = (Debt capital / Company assets) x 100
Imagine that your company has total assets equal to R$200,000. In relation to third-party capital, it represents R$50,000. In this case, the EG ratio will be equal to 25%, meaning that a quarter of the company’s assets belong to obligations with third parties.
In practice, the lower this index, the lower your company’s debt. Therefore, it is worth using the indicator regularly to monitor the evolution of the number.
2. Many bills to pay in the short term
Another warning sign is the debt term: high amounts owed in the short term can lead to payment difficulties. In this case, an index that can be monitored by the company is the debt composition, or CE.
It is related to the company’s debt term, according to the dates for fulfilling obligations. To perform the calculation, you need to have access to the amount of short-term and long-term liabilities. Then, simply apply the formula:
CE Ratio = (Short-term liabilities / Long-term liabilities) x 100
For example: if your company’s short-term liabilities amount to R$10,000 and its long-term liabilities amount to R$8,000, the CE ratio will be 125%. This could be a warning sign for the company regarding the need for resources and liquidity to pay off its debts.
3. Lack of financial planning
Finally, it is also possible to check for signs of debt through the business’s financial routine. One of the main points of attention in this context is the lack of control and specialized financial planning in the company.
When there is no planning, managers will not have a broad view of the business’s finances. As a result, they may make mistakes when calculating working capital and using third-party resources to maintain the business.
Over time, the debt rate can increase considerably, especially in times of crisis. As a result, the company may become in default and have to bear unnecessary costs.