Do you remember riding the teeter totter at the park when you were a kid? The hard wooden seat attached to the metal pole with the flaking paint of many colors. The advantage always went to the heavier person who could keep you suspended in the air indefinitely…or until they were called home for dinner! A classic example of leverage.
leverage ratios are an important category of business performance indicators. Debt is a powerful tool to grow a business and create positive leverage. But debt used incorrectly can put your company into an unrecoverable skid. Stay away from credit crises. Keep a close eye on your leverage by using these leverage ratios:
Debt-to-equity: Measures the ratio of how much debt you have to how much equity you have. The correct ratio depends upon your industry and is measured relative to your competitors.
Debt-to-capital: Measures the ratio of how much debt you have to the total capital of the company including debt and equity. Or look at it as how much of the company’s assets are financed with debt.
The debt service coverage ratio measure your ability to comfortably pay loan interest and principal. This ratio should be above 1:1 or it is an obvious sign you are not able to make your loan payments.
The appropriate level of debt depends on the result of operations and liquidity. Closely monitor the change in your leverage ratios to make smart debt capital choices.
- How is your Business Borrowing Fitness? (proborrower.wordpress.com)