Long-Term Debt Coverage Ratio
Investors analyze various financial metrics to distinguish companies that are economically afloat from those just scraping by. By watching ratios closely, these investors want to make sure they see eye-to-eye with corporate leadership on profitability and liquidity. Solvency metrics include long-term debt coverage ratio and working capital.
To manage long-term liabilities, corporate leadership focuses on areas costing the company money and attempts to prevent waste. Senior executives also emphasize external factors, such as the state of the economy and lending rates. A long-term debt is a liability that matures within a period exceeding one year. Examples include notes due and bonds payable. Conversely, short-term debts mature within 12 months and include vendors payable and taxes due.
Controlling a company’s long-term debt pile is a constant, collective effort. Top leadership seeks feedback from various personnel before the firm borrows and agrees to a long-term repayment window. Diversity in viewpoints allows senior executives to expand their perspectives beyond a small circle of loyal, like-minded advisers. Long-term debt management involves talking periodically with external experts, such as investment bankers, risk analysts and financial auditors. Constantly monitoring corporate liabilities prevents cash shortfalls, which are generally detrimental to operating activities.
The long-term debt coverage ratio indicates whether a company can repay its existing liabilities and take on additional debt without jeopardizing its survival. It is an efficiency metric, meaning it shows investors how adeptly a company manages its resources. The metric equals net profit plus any non-cash expenses divided by the principal amount of long-term debt. Accountants add non-cash expenses back to net profit because these charges reduce net income, yet the borrowing firm does not disburse any funds. An example is depreciation, which enables a firm to allocate its fixed-asset costs over several years.
Besides long-term debt coverage ratio, financial managers rely on other indicators to gauge solvency and liquidity. For example, managers use debt-to-equity ratio and working capital. Debt-to-equity ratio equals total debts divided by total equity and reflects an organization’s vulnerability to risk. Working capital gauges short-term cash and equals short-term assets minus short-term debts.
For businesses, managing solvency ratios means paying sufficient attention to items that make up debt indicators and analyzing how they affect long-term profitability. It also means gradually removing or reducing operating obstacles that stand in the way of risk management. These include cost overruns and budget deficits, all of which are part of periodic performance reports. Net profit and operating expenses are income statement items, whereas debts are balance sheet components.