Business debt is a crucial part of any company’s financial portfolio. Debt can help businesses stretch their cash flow while ensuring they have the capital for critical expenses. It can also help some businesses grow by freeing up cash for other endeavors.
That debt, though, has to be managed so it doesn’t get out of control. That’s why business owners and finance managers calculate the debt ratio. This ratio highlights a company’s financial position relative to the outstanding liabilities it has.
Debt ratios can be confusing for some business owners because a few different ratios can apply. Here’s everything businesses need to know about commercial debt ratios and their impact on operations.
What is a Commercial Debt Ratio?
The debt ratio of a business is a measure of how much of their assets have debt liabilities attached to them. The debt ratio is also called the debt-to-asset ratio, not to be confused with the debt-to-equity ratio.
Commercial debt ratios take all assets into account, but there is also a long-term debt-to-asset ratio that analyzes only the outstanding liabilities a business will have for longer than a year.
Common types of assets businesses include in their debt ratio are:
- Liquid assets, like cash and funds in checking and savings accounts
- Capital assets invested in variable products, like stocks and mutual funds
- Real property assets, like buildings and land titles
- Inventory, including both finished products and production inputs
- Outstanding invoices, including all accounts receivables balances
Obligations that are often included in the debt ratio are:
- Equipment financing, including office equipment and heavy machinery
- Unsecured business loans, like SBA loans and lines of credit
- Alternative financing, including merchant cash advances and invoice financing
- Property debt, including office leases and commercial mortgages
- Outstanding invoices, including all accounts payable balances
This information is pulled from a company’s balance sheet and is used to draw conclusions about its financial health. It might be helpful to notate short-term and long-term debt accounts for future use.
There are endless formulas for businesses to analyze their financial position, but the debt ratio is a unique calculation that helps measure risk. To better understand the importance of this tool, review these frequently asked questions about commercial debt ratios.
What Does Debt Ratio Measure?
The primary reason to calculate the debt-to-asset ratio is to find out how much of a company’s assets have been purchased using some kind of financing or debt vehicle. A high debt ratio indicates that a business used a lot of debt to fund operations while a low debt ratio highlights that more assets were purchased with equity than debt.
It’s a tool for business owners and finance managers to check their company’s health, and it can be used by creditors to determine whether or not to lend to an organization.
Debt Ratio Formula
While it requires a bit of calculating to get the initial data, the debt ratio formula is simple:
- Debt ratio = total debt / total assets
Businesses that want to calculate their long-term debt ratio can make a slight adjustment to the formula by excluding debt obligations that are under a year:
- Long-term debt ratio = total long-term debt / total assets
The number can be represented as a decimal or a percentage. Most financial software can calculate this if the data is properly managed by a business.
Is It Better to Have a High Debt Ratio or a Low Debt Ratio?
This depends on several factors. First, some industries rely on credit-based transactions to manage their day-to-day operations. These industries will generally have high debt ratios comparatively speaking. It’s also important to consider the business growth stage. Companies that are experiencing a lot of growth or are looking for venture capital might have high debt ratios while still being financially stable.
For example, the industry average debt ratio for agricultural production is 44% while the debt ratio average for the tobacco products industry is 77%. Investment professionals, on the other hand, have a low industry average of 23%.
This means, in general, a business that has a debt ratio exceeding these numbers could have a hard time securing additional financing. However, businesses with a low debt ratio for industries that typically see high debt ratios could indicate inexperience and a lack of revenue to support more debt.
What is a Good Debt Ratio?
There is no definitive “good” debt ratio. In general, a “high” debt ratio is anything over 60% while a “low” debt ratio is under 40%. Businesses that fall outside of these ranges present a greater risk to most credit providers.
However, as mentioned, a good debt ratio can vary from industry to industry. It can also vary from region to region, which makes it difficult to pinpoint the “right” debt ratio for businesses. That said, most investors want to see debt ratios between 30% and 60%.
Difference Between the Debt-to-Equity Ratio
The debt ratio usually refers to the debt-to-asset ratio, which is different from the debt-to-equity ratio. Where the debt-to-asset ratio compares how much debt financed a company’s assets, the debt-to-equity ratio analyzes how much of the assets were purchased using equity.
This is the debt-to-equity formula:
- Debt-to-equity ratio = total debt / total shareholder equity
Essentially, the difference between the two is how the assets were purchased. More equity means a company has the capital to cover its liabilities if the economy collapses or there is a disruption in the industry.
Many investors will use a combination of the debt-to-equity ratio, the cash ratio, and the current ratio to determine a company’s financial health. These formulas separate short-term and long-term debt for a different comparison of the portfolio.
What is a Good Debt-to-Equity Ratio?
As with the debt ratio, a good debt-to-equity ratio varies depending on several factors, one of which is the industry. It’s not uncommon for capital-intensive industries, like manufacturing and finance, to have high ratios compared to other industries.
However, from an investment standpoint, there is an optimal debt-to-equity ratio: 2.0. A ratio of 2.0 means that approximately 66% of a company’s financing comes from its equity. This also indicates a lower debt-to-asset ratio, suggesting the business is lower risk.
There are downsides to low debt-to-equity ratios though. If the number drops too low, it can signal to investors or competitors that the company could benefit from an acquisition or buyout. It can also indicate that a company doesn’t have the necessary growth to sustain long-term debt.
It’s also possible for businesses to have negative debt-to-equity ratios. This can be a result of additional debt when profits are low, paying out dividends that exceed the shareholders’ equity, or taking a financial loss because of dividend payments. A negative debt-to-equity ratio is generally a red flag to creditors and investors.
Practical Tips for Managing and Balancing Commercial Debt Ratios
Business debt can be critical for sustainable growth. However, taking on too many liabilities without a solid financial plan can be devastating for many companies. Debt ratios are often key to securing business loans and other investments, so it’s important to establish procedures that ensure a balanced portfolio.
Regardless of the industry, there are practical tips businesses can follow to help them manage commercial debt ratios, including the debt-to-equity ratio:
Keep Diligent Financial Records
The fastest way for businesses to let their debt get out of control is to neglect their records. It might start with a contract oversight for a small business lease or putting off the entry of key balance sheet data. This can create delays in collecting the right data, not to mention it can lead to late payments or collection activity.
Limit Short-Term Credit Accounts
Businesses typically renew short-term credit accounts more often than long-term liabilities. Companies that utilize a lot of short-term debt might be viewed as riskier than their counterparts. Their debt ratio is constantly fluctuating, and the short-term debt affects working capital until it is paid in full.
Minimize Dividend Payments
While shareholders certainly want to see dividend payments, large payouts can create serious financial problems for businesses. The dividends can create a loss for the company and cause a negative debt-to-equity ratio. A negative debt-to-equity ratio indicates a high debt-to-asset ratio, which also indicates a risk to investors.
It’s also important to take care of outstanding obligations when profits are high. This can help balance debt and equity discrepancies that could hurt the company’s financial position.
Establish a Plan
Commercial debt ratios are just one tool in a box that helps businesses analyze their financial health. It’s not enough to invest time in calculating a debt-to-asset ratio if other ratios can’t be compared. That’s why businesses must establish a plan for maintaining digital records.
When accounting and financial software is regularly maintained, financial professionals are better able to pull the data they need. Create a routine for importing data and reconciling monthly income and expenses, then schedule a time to review debt formulas after each bank reconciliation is completed. This will help establish trends in the debt ratio over time, a key metric for sustainable growth.