Measure of the Efficiency of Debt
The use of external debt often is necessary to pay for major business investments or opportunities. When using debt, companies need to measure the efficiency of debt. Debt measurements allow owners and managers to determine how well the company uses financial leverage to advance the business and increase profits from new operations.
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Return on Investment
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The return on investment (ROI) formula is a basic calculation to evaluate the efficiency of debt used by a business. The basic formula is to subtract the cost of an investment or opportunity from the investment's gain, and divide that figure by the cost of the investment or opportunity. For example, assume a company secured $150,000 in financial leverage for a new business department. Sales from the new department currently total $175,000. The ROI for this investment and use of debt is 16.7 percent.
Times Interest Earned
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Times interest earned is another debt efficiency ratio. This particular formula indicates how well a business can pay for debt from cash earned through expanded operations. Accountants divide the company's earnings by the total interest payable for loans or other debt. For example, assume a company has $45,000 in net earnings and $95,000 in total interest payable for the year. The company can only cover 47 percent of interest payments through current earnings. A high ratio is typically preferable.
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Benefits
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Measuring debt efficiency often helps a company ensure that it does not over-leverage its operations. For example, a company can use a credit line to make periodic withdrawals and invest debt into new opportunities. Each quarter, accountants can review the debt efficiency using the previous two formulas. Acceptable ratios indicate the company is using the debt efficiently and can continue taking withdrawals. Unacceptable ratios can indicate a change is necessary prior to pulling more debt into the business to increase future financial benefits.
Considerations
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Other ratios also help measure the effects of debt on a business. While they do not specifically measure debt efficiency, they do calculate how much debt a company uses. This allows owners and managers to benchmark debt use against the industry standard. Companies typically prefer to be on par with the industry to ensure they do not have too much financial leverage. Common debt ratios include the debt ratios and debt-to-equity ratio. These measure the long-term solvency of a business.
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