What is a debt ratio?
The debt ratio of a given business reveals whether or not it has loans and, if so, how its credit financing compares to its assets. It is calculated by dividing total responsibilities by total assets, with higher debt ratios indicating higher degrees of debt financing. Debt ratios can be used to describe the financial health of individuals, businesses or governments. Investors and lenders calculate a company’s debt ratio from its principal financial state, as they do with other accounting ratios.
Whether or not a debt ratio is good depends on contextual factors. But it is actually difficult to find an absolute number. Keep reading to learn more about what these ratios mean and how they are used by businesses.
Key points to remember
- Whether or not a debt ratio is “good” depends on the context: the company’s industrial sector, the prevailing interest rate, and so on.
- In general, many investors are looking for a company with a debt ratio between 0.3 and 0.6.
- From a pure risk perspective, debt ratios of 0.4 or less are considered better, while a debt ratio of 0.6 or more makes borrowing money more difficult.
- While a low debt ratio suggests greater creditworthiness, there is also a risk associated with a business with too little debt.
What some debt ratios mean
From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios. Since interest on a debt must be paid regardless of the profitability of the business, excessive debt can jeopardize the whole operation if cash flow runs out. Companies unable to service their own debt may be forced to sell assets or file for bankruptcy.
A higher debt ratio (0.6 or more) makes it more difficult to borrow money. Lenders often have debt ratio limits and do not extend additional credit to businesses that are over-indebted. Of course, there are also other factors, such as solvency, payment history and professional relationships.
On the other hand, investors rarely want to buy the shares of a company with an extremely low debt ratio. A debt-to-equity ratio of zero would indicate that the company is not financing the increased operations through debt at all, which limits the total return that can be realized and passed on to shareholders.
While the rate of endettement is a better measure of the opportunity cost than the basic debt ratio, this principle remains true: risk associated with too little debt. This is because debt is a cheaper form of financing than equity financing. It is the process by which companies raise capital by selling additional stocks to meet short-term needs.
Leverage financial strength
Typically, larger, more established businesses are able to push their ledger liabilities further than newer or smaller businesses. Large companies tend to have stronger cash flows and they are also more likely to have negotiable relationships with their lenders.
Debt ratios are also sensitive to interest rates; all interest-bearing assets carry interest rate risk, whether they are corporate loans or bonds. The same amount of capital costs more to repay at an interest rate of 10% than at 5%.
During times of high interest rates, good debt ratios tend to be lower than during times of low interest rates.
There is a feeling that any analysis of the debt ratio must be done on a company-by-company basis. Balancing the Double Risk of Debt—credit risk and the opportunity cost – is something all businesses need to do.
However, some sectors are more prone to significant debt than others. Capital-intensive businesses, such as manufacturing or utilities, can get away with slightly higher debt ratios when expanding their business. It is important to assess industry standards and historical performance against debt levels. Many investors are looking for a company with a debt ratio between 0.3 and 0.6.
Thomas M. Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp., Hilton Head, South Carolina
Debt ratios also apply to the financial situation of individuals. Of course, each person’s situation is different, but as a rule, different types of debt ratios need to be considered, including:
- Non-mortgage debt-to-income ratio: This indicates what percentage of income is used to pay off non-mortgage debt. This compares the annual payments for servicing all consumer debt, excluding mortgage payments, divided by your net income. This should be 20% or less of net income. A ratio of 15% or less is healthy, and 20% or more is considered a warning sign.
- Debt-to-income ratio: This indicates the percentage of gross income that goes towards housing costs. This includes the mortgage payment (principal and interest) as well as property taxes and home 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 to pay all recurring debt payments (including mortgages, credit cards, car loans, etc.) divided by gross income. This should be 36% or less of gross income.