Many owners borrow money to setup the business. Sometimes it is due to the lack of capital with the owner. Other times, the owners have the capital to start but they believe in the higher potential for the business, so they borrow additional money to increase the returns (I will cover this more while introducing the concept of Leverage in Balance Sheet section).
For our hot dog business example, let’s say that the hot dog business owner did not have much capital to start his business, i.e. enough money buy the stalls, rent a shop, buy the ingredients for hot dogs, etc. So he goes to either a bank or friends for a loan and promises them to return the money in certain period of time with an interest. Borrowing money mostly creates two obligations for the business:
- Paying a timely interest until maturity of the loan, although some loans can also be agreed with payment on the end date of the loan
- Paying back the principal borrowed in the first place
When evaluating the earning power of the business, it is advised that the investor looks at the interest expense in relation to the operating profit. If the operating profit is not able to fulfil the interest obligations, it is not really a business one should invest in.
To see how the company has performed in relation to its interest obligations, we should look at the Interest Coverage Ratio that is defined as below:
Interest Coverage Ratio = Operating Income/ Interest Expense
Higher the ratio over the years, the better it is from investing perspective.
We will talk more about Debt (money borrowed) in Balance Sheet segment to see if too much debt is an issue for the company.