Debt ratios can be used to describe the financial health of individuals, businesses or governments. Like other accounting ratios, investors and lenders calculate the debt ratio for a business from major financial statements.
What a Debt Ratio Does
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. Whether or not a debt ratio is good depends on the context within which it is being analyzed.
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 over-leveraged. Of course, there are other factors as well, such as credit worthiness, 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.
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 10% 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.
Thomas M. Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp, Hilton Head, SC
Of course, each person’s circumstance is different, but as a rule of thumb there are different types of debt ratios that 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.