How can you determine if a company has too much debt? (2024)

1. Calculate the company's debt-to-equity ratio by dividing its total debt by its total equity.2. Calculate the debt-to-asset ratio by dividing the total debt by the total assets. 3. Evaluate interest coverage ratio by dividing the company's earnings before interest and taxes (EBIT) by its interest expense. 4. Assess debt service coverage ratio by dividing the company's net operating income by its total debt service obligations.5. Compare company's debt ratios to industry benchmarks or peers within the same sector.6. Evaluate the company's cash flow to assess its ability to generate sufficient cash.7. Review the company's credit rating and debt covenants.8. Consider the company's growth prospects and investment opportunities.

A high ratio means outside borrowings are used which requires generating significant cash flow to repay principal borrowed and interest expense.On the other hand, a low ratio means business is financed by shareholder's equity. Let's say you're analyzing a major retail chain. Their debt-to-equity ratio is 1.5. This explains that for every $1.50 of debt they have, there's $1.00 invested by shareholders. This suggests a moderate level of leverage. The company is using debt-to-finance business operations, but it's not overly reliant on borrowed funds.There is no ideal debt-to-equity ratio that applies universally; however, it can be compared with industry and benchmarked.

Definitely this is one of the easiest mechanisms to identify if an entity is overgeared or not. Alternatively assessing cashflow and interests are good indicators as well

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1-Debt Ratios: Analyze Debt-to-Equity (D/E) and Debt-to-Asset ratios. Higher ratios suggest more debt financing, potentially risky. Industry benchmarks are crucial for comparison.2- Interest Coverage: This ratio shows if a company earns enough to cover interest payments. A lower ratio indicates potential debt servicing issues.3- Cash Flow: Look at cash flow generation. Can the company comfortably cover debt obligations with its current income?Debt tolerance varies by industry and growth stage. Startups may have higher debt for initial growth, while established firms might have lower ratios. Consider interest rates too - lower rates make debt more manageable.

This metric provides insights into a company's ability to repay its debt using its operating cash flow before excluding interest, tax, depreciation, and amortization.It provides information that in case the EBITDA is directed towards debt repayment, then how many years it takes to knock-off the borrowings. There is no ideal ratio but one should considered factors like capital-intensive industries might naturally have a higher debt-to-EBITDA ratio compared to service-oriented industries.

Debt Service Coverage Ratio(DSCR) Also needs to check the company's ability to repay debt.DSCR- EBITDA/ Interest+ PrincipalMinimum 1 DSCRDSCR -1.33 Tight1.5 Moderate1.7 Adequate as per bank (It may vary bank to bank)

Borrowings comes with interest obligations. This metric explains about how many times a business can cover its interest obligations with its earnings before taxes and other expenses.Interest Coverage Ratio = Operating Income / Interest ExpenseLet's analyze a manufacturing company. Their interest coverage ratio is 5. This means they can cover their interest expenses five times over with their operating income. This is a strong ratio, indicating the company has a significant buffer and can comfortably manage its debt obligations.

To calculate the interest coverage ratio, follow these steps:- Determine the company's earnings before interest and taxes (EBIT). This can usually be found on the company's income statement.- EBIT = Operating Income + Non-operating Income- Identify the company's interest expenses for the same period. Interest expenses can be found on the income statement or in the notes to the financial statements.- Use the following formula to calculate the interest coverage ratio:Interest Coverage Ratio = EBIT / Interest ExpensesThe interest coverage ratio helps determine if a company has too much debt by providing insight into its ability to service its debt obligations.

It evaluates the relationship between the cash flow and its borrowings, shedding light on the company's liquidity and leverage.Cash Flow-to-Debt Ratio= Total Debt /Annual Cash Flow. Example: Annual Cash Flow: 1,500,000Total Debt: 3,500,000Cash Flow-to-Debt Ratio=1,500,000/3,500,000=0.43The cash flow-to-debt ratio indicates that it can cover 43% of its total debt within a year based on its annual cash flow.

The best way to dertmine if a company's debt is escessive is to check the interest cover ratio. The moment a company is paying too much of its revenue on debt servicing, then the debt is too high. Just like Nigeria is currently experiencing where over 80% of its revenue goes to debt servicing.

The various ratio determined should be compared it with industry trends to get more understanding on ideal ratio. Also, one should also review the cash flows from financing activities in the cash flow statement. Understand the accounting policies on borrowing cost, implication of major lease agreement signed which is an obligation affecting the cash flow impacting the profitability.