What Is a Good Debt Ratio (and What’s a Bad One)?

Reviewed by Somer AndersonFact checked by Pete RathburnReviewed by Somer AndersonFact checked by Pete Rathburn

A debt ratio, also called a “debt-to-income (DTI) ratio,” can be used to describe the financial health of individuals, businesses, or governments. A company’s debt ratio tells the amount of leverage it’s using by comparing its debt and assets. It is calculated by dividing total liabilities by total assets, with higher ratios indicating higher degrees of debt financing. Debt ratios vary greatly among industries, so when comparing them from one company to the other, it’s important to do so within the same industry.

You can calculate the debt ratio of a company from its financial statements. Whether or not it’s a good ratio depends on contextual factors; there is no universal number. Let’s take a look at what these ratios mean, what the variations are, and how they’re used by corporations.

Key Takeaways

• Whether or not a debt ratio is “good” depends on contextual factors, including the company’s industrial sector, the prevailing interest rate, and more.
• Investors usually look for a company to have a debt ratio between 0.3 (30%) and 0.6 (60%).
• From a pure risk perspective, debt ratios of 0.4 (40%) or lower are considered better, while a debt ratio of 0.6 (60%) 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

In terms of risk, ratios of 0.4 (40%) or lower are considered better ones. As 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 debt ratio of 0.6 (60%) or higher makes it more difficult to borrow money. Lenders often have debt ratio limits and won’t 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. This is because a 0% ratio means that the firm never borrows to finance increased operations, 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, one principle still holds true: There is some risk associated with having too little debt. This is because debt financing is usually cheaper form than equity financing. The latter is how corporations usually raise capital, selling additional shares to address short-term needs.

Leveraging Financial Strength

Larger and more established companies generally can push the liabilities side of their ledgers further than smaller or newer companies, because they tend to have more-solidified cash flows and 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%.

Important

During times of high interest rates, good debt ratios tend to be lower than during low-rate periods.

All debt ratio analysis should be done on a company-by-company basis. This is because while all companies must balance the dual risks of debt—credit risk and opportunity cost—certain sectors are more prone to large levels of indebtedness than others. 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 (30%) and 0.6 (60%).

Advisor Insight

Thomas M. Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp., New York, N.Y. and Alliance Global Partners, Hilton Head, S.C.

Debt ratios also apply to individuals’ financial status. Of course, each person’s circumstance 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 a person’s income is used to service non-mortgage-related debts. It compares annual payments that 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, while higher than 20% is considered a warning sign.
• Housing debt–to-income ratio – This indicates the percentage of a person’s gross income that goes toward housing costs. It includes mortgage payments (principal and interest), as well as property taxes and property insurance, divided by gross income. This should be 28% or less of gross income.
• Total debt-to-income-ratio – This identifies the percentage of income that goes toward paying all of a person’s recurring debt payments (including mortgage, credit cards, car loans, etc.) divided by gross income. This should be 36% or less of gross income, though some lenders will go as high as 43%.

What Is a Good Debt Ratio?

There is no one figure that characterizes a “good” debt ratio, as different companies will require different amounts of debt based on the industry in which they operate. For example, airline companies may need to borrow more money, because operating an airline requires more capital than a software company, which needs only office space and computers.

Debt ratios must be compared within industries to determine whether a company has a good or bad one. Generally, a mix of equity and debt is good for a company, though too much debt can be a strain. Typically, a debt ratio of 0.4 (40%) or below would be considered better than a debt ratio of 0.6 (60%) or 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 restructuring.

The Bottom Line

Understanding a company’s debt profile is a critical aspect in 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.

Read the original article on Investopedia.