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Debt Ratio: Interpreting, Calculating, and Optimizing Financial Health

joe June 16, 2021

To find a comfortable debt ratio, companies should compare themselves to their industry average or direct competitors. The debt ratio is valuable for evaluating a company’s financial structure and risk profile. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low. A company with a negative net worth can have a negative debt-to-equity ratio. A negative D/E ratio means that the total value of the company’s assets is less than the total amount of debt and other liabilities.

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In a low-interest-rate environment, borrowing can be relatively cheap, prompting companies to take on more debt to finance expansion or other corporate initiatives. It gives stakeholders an idea of the balance between the funds provided by creditors and those provided by shareholders. The sum of all these obligations provides an encompassing view of the company’s total financial obligations.

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• Both ratios, however, encompass all of a business’s assets, including tangible assets such as equipment and inventory and intangible assets such as copyrights and owned brands.
• In some cases, a higher ratio can be better than a lower one when comparing companies in different industries.
• The debt ratio aids in determining a company’s capacity to service its long-term debt commitments.
• Lenders look at debt-to-income ratios because research shows borrowers with high DTIs have more trouble making consistent payments.
• At first glance, this may seem good — after all, the company does not need to worry about paying creditors.

Banks often have high D/E ratios because they borrow capital, which they loan to customers. If a D/E ratio becomes negative, a company may have no choice but to file for bankruptcy. The investor has not accounted for the fact that the utility company receives a consistent and durable stream of income, so is likely able to afford its debt. For this reason, it’s important to understand the norms for the industries you’re looking to invest in, and, as above, dig into the larger context when assessing the D/E ratio. Airlines, as well as oil and gas refinement companies, are also capital-intensive and also usually have high D/E ratios. To interpret a D/E ratio, it’s helpful to have some points of comparison.

Risks and Benefits of Varying Debt Ratios

• This ratio provides a snapshot of a company’s short-term liquidity and its ability to meet immediate financial obligations using its most liquid assets.
• The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation.
• But before that, let’s prepare ourselves for the process of deciphering the implications of different debt ratios.
• Of note, there is no “ideal” D/E ratio, though investors generally like it to be below about 2.
• Investors can use the D/E ratio as a risk assessment tool since a higher D/E ratio means a company relies more on debt to keep going.
• When interpreting the D/E ratio, you always need to put it in context by examining the ratios of competitors and assessing a company’s cash flow trends.
• Make sure you use the total liabilities and the total assets in your calculation.

In some cases, a higher ratio can be better than a lower one when comparing companies in different industries. For example, if a company’s debt ratio keeps rising over time, it implies that it needs to take on debt to buy assets to fuel growth. The debt-to-equity ratio is a way to assess risk when evaluating a company. The ratio looks at debt in relation to equity, providing insights into how much debt a company is using to finance its operations. Remember, understanding your debt ratio is a critical part of managing financial health, whether you’re running a business or considering an investment decision. There’s more to optimal debt ratios than just industry considerations.

This is because the industry is capital-intensive, requiring a lot of debt financing to run. And, when analyzing a company’s debt, you would also want to consider how mature the debt is as well as cash flow relative to interest payment expenses. https://www.bookstime.com/articles/reversing-entries When interpreting the D/E ratio, you always need to put it in context by examining the ratios of competitors and assessing a company’s cash flow trends. Below is an overview of the debt-to-equity ratio, including how to calculate and use it.

Understanding Leverage

As such, a higher number is usually (but not always) seen as worse than a lower ratio. More on the unusual cases in a moment, but first, I’ll flesh out why the ratio is so important. Or said a different way, this company’s liabilities are only 50 percent of its total assets. Essentially, only its creditors own half of the company’s assets and the shareholders own the remainder of the assets.

• The nature of the baking business is to take customer deposits, which are liabilities, on the company’s balance sheet.
• As businesses mature and generate steady cash flows, they might reduce their reliance on borrowed funds, thereby decreasing their debt ratios.
• The debt-to-equity ratio (aka the debt-equity ratio) is a metric used to evaluate a company’s financial leverage by comparing total debt to total shareholder’s equity.
• This reflects a certain ambiguity between the terms debt and liabilities that depends on the circumstance.
• The debt ratio is a measurement of how much of a company’s assets are financed by debt; in other words, its financial leverage.

The periods and interest rates of various debts may differ, which can have a substantial effect on a company’s financial stability. In addition, the debt ratio depends on accounting information which may construe or manipulate account balances as required for external reports. Leverage ratios represent the extent to which a business is utilizing borrowed money. Having high leverage in a firm’s capital structure can be risky, but it also provides benefits. “Ratios over 2.0 are generally considered risky, whereas a ratio of 1.0 is considered safe.”

Acceptable levels of the total debt service ratio range from the mid-30s to the low-40s in percentage terms. The debt-to-equity ratio (aka the debt-equity ratio) is a metric used to evaluate debt ratio a company’s financial leverage by comparing total debt to total shareholder’s equity. In other words, it measures how much debt and equity a company uses to finance its operations.

Why are D/E ratios so high in the banking sector?

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Joe Gelata

Joe helps clients achieve maximum output from their revenue engine by leveraging best practice business processes and technology such as marketing automation, CRM, and analytics platforms. With experience in sales and marketing from an agency and client perspective Joe is well positioned to build new and streamline existing business processes, automate them, and identify further opportunities for revenue growth.