What Is a Good Debt Ratio?

What Is a Debt Ratio?

The debt ratio for a given company reveals whether or not it has loans and, if so, how its credit financing compares to its assets. It is calculated by dividing total liabilities 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 the debt ratio for a company from its major financial statements, as they do with other accounting ratios.

Whether or not a debt ratio is good depends on the contextual factors. But 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.

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 are able to 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%.

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.