The debt ratio of a company tells the amount of leverage it's using by comparing total debt to total assets. It is calculated by dividing total liabilities by total assets, with higher debt ratios indicating higher degrees of debt financing. Debt ratios vary greatly amongst industries, so when comparing them from one company to the other, it is important to do so within the same industry.
Debt ratios can be used to describe the financial health of individuals, businesses, or governments.
Investors and lenders calculate the debt ratio of a company from its financial statements. Whether or not a debt ratio is good depends on the contextual factors. It's actually hard to come up with an absolute number. Keep reading to learn more about what these ratios mean and how they're used by corporations.
Key Takeaways
- Whether or not a debt ratio is "good" depends on the context: the company's industrial sector, the prevailing interest rate, etc.
- In general, many investors look for a company to have a debt ratio between 0.3 and 0.6.
- From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.
- While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.
What Certain Debt Ratios Mean
From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios. Since the interest on a debt must be paid regardless of business profitability, too much debt may compromise the entire operation if cash flow dries up. Companies unable to service their own debt may be forced to sell off assets or declare bankruptcy.
A higher debt ratio (0.6 or higher) makes it more difficult to borrow money. Lenders often have debt ratio limits and do not extend further credit to firms that are overleveraged. Of course, there are other factors as well, such as creditworthiness, payment history, and professional relationships.
On the other hand, investors rarely want to purchase the stock of a company with extremely low debt ratios. A debt ratio of zero would indicate that the firm does not finance increased operations through borrowing at all, which limits the total return that can be realized and passed on to shareholders.
While the debt-to-equity ratio is a better measure of opportunity cost than the basic debt ratio, this principle still holds true: There is some risk associated with having too little debt. That's because debt is a cheaper form of financing than equity financing. This is the process by which corporations raise capital by selling additional shares to address short-term needs.
Leveraging Financial Strength
Generally speaking, larger and more established companies can push the liabilities side of their ledgers further than newer or smaller companies. Larger companies tend to have more solidified cash flows, and they are also more likely to have negotiable relationships with their lenders.
Debt ratios are also interest-rate sensitive; all interest-bearing assets have interest rate risk, whether they are business loans or bonds. The same principal amount is more expensive to pay off at a 10% interest rate than it is at 5%.
During times of high interest rates, good debt ratios tend to be lower than during low-rate periods.
There is a sense that all debt ratio analysis must be done on a company-by-company basis. Balancing the dual risks of debt—credit risk and opportunity cost—is something that all companies must do.
Certain sectors are more prone to large levels of indebtedness than others, however. Capital-intensive businesses, such as manufacturing or utilities, can get away with slightly higher debt ratios when they are expanding operations.
It is important to evaluate industry standards and historical performance relative to debt levels. Many investors look for a company to have a debt ratio between 0.3 and 0.6.
Advisor Insight
Thomas M. Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp., Hilton Head, SC
Debt ratios apply to individuals' financial status, too. Of course, each person’s circ*mstance is different, but as a rule of thumb, different types of debt ratios should be reviewed, including:
- Non-mortgage debt to income ratio: This indicates what percentage of income is used to service non-mortgage-related debts. This compares annual payments to service all consumer debts—excluding mortgage payments—divided by your net income. This should be 20% or less of net income. A ratio of 15% or lower is healthy, and 20% or higher is considered a warning sign.
- Debt to income ratio: This indicates the percentage of gross income that goes toward housing costs. This includes mortgage payment (principal and interest) as well as property taxes and property insurance divided by your gross income. This should be 28% or less of gross income.
- Total ratio: This ratio identifies the percentage of income that goes toward paying all recurring debt payments (including mortgage, credit cards, car loans, etc.) divided by gross income. This should be 36% or less of gross income.
What Is a Good Debt Ratio?
There is no real "good" debt ratio as different companies will require different amounts of debt based on the industry they operate in. Airline companies may need to borrow more money because operating an airline is more capital-intensive than say a software company that needs only office space and computers.
Debt ratios must be compared within industries to determine whether a company has a good or bad debt ratio. Generally, a mix of equity and debt is good for a company, and too much debt can be a strain on a company's finances. Typically, a debt ratio of 0.4 or below would be considered better than a debt ratio of 0.6 and higher.
How Do You Calculate the Debt Ratio?
To calculate the debt ratio, divide total liabilities by total assets. These numbers can be found on a company's balance sheet in its financial statements.
How Can a Company Improve Its Debt Ratio?
A company can improve its debt ratio by cutting costs, increasing revenues, refinancing its debt at lower interest rates, improving cash flows, increasing equity financing, and possibly restructuring.
The Bottom Line
Understanding a company's debt profile is one of the critical aspects of determining its financial health. Too much debt and a company may be in danger of not being able to meet its interest and principal payments, as well as creating a strain on its finances.
Too little debt and a company may not be utilizing debt in a healthy way to grow its business. Understanding the debt ratio within a specific context can help analysts and investors determine a good investment from a bad one.
