Debt allows companies to aggressively expand and pursue opportunities. But excessive leverage can cripple even thriving businesses when circumstances deteriorate. Debt ratios provide an important barometer of a company’s financial health and risk exposure.
Let’s examine the key ratios for evaluating debt levels and how leverage impacts organizations.
The Main Debt Ratios and What They Measure
Debt-to-Equity Ratio – This compares total liabilities to shareholder equity by dividing total debt by equity. The ratio shows the degree of leverage used by a company to finance operations and growth. Most healthy ranges fall between 1.0 to 2.0. Higher ratios indicate greater risk.
Debt-to-Assets Ratio – Total debt is divided by total assets to measure the percentage of assets financed through debt. A lower percentage is preferable. Conservative ratios are below 0.60, while highly leveraged firms may exceed 0.80.
Debt-to-EBITDA Ratio – Earnings before interest, taxes, depreciation and amortization (EBITDA) measures operating cash flow. Dividing total debt by EBITDA indicates the ability to service debt. Ratios above 4.0x or 5.0x are troubling.
Analyzing trends across all three ratios over time provides the most complete view of debt usage and capacity. Spikes in any metric warrant further investigation.
Benefits and Risks of Leverage
Judiciously using debt provides key advantages. Borrowing gives companies ready access to capital for growth initiatives – expanding facilities, developing products, or acquiring competitors. Interest expense is also tax deductible, providing savings.
However, high debt leaves little margin for error. Rising interest rates quickly increase borrowing costs, diverting cash from operations to interest payments. Excess leverage also magnifies losses in economic downturns or disruptions.
Many heavily leveraged companies faced existential crises when profits evaporated during the pandemic. Those carrying lower debt burdens weathered the storm far better.
Evaluating Debt in Full Context
Assessing leverage requires looking at the company’s entire situation. Differences across industries makes comparison difficult – leverage standards vary widely. Risk tolerance also differs.
For example, large tech firms use little debt, maintaining very low ratios. Telecoms and utilities habitually leverage their expensive infrastructure, accepting higher ratios. Within sectors, business models impact debt appetite.
Management outlooks also shape leverage. Conservative executives keep tight control of debt levels. More aggressive managers push boundaries and operate with higher ratios and risk.
Investors evaluating debt should consider the company’s competitive environment, capital intensity, and management’s financial philosophy.
The Bottom Line
Debt allows companies to pursue growth aggressively. But imprudent borrowing leaves firms vulnerable. High debt ratios could indicate an unsustainable situation with inflated risk.
Tracking leverage metrics over time and against competitors gives key insights on financial health. Maintaining reasonable debt levels ensures stability during unpredictable downturns while remaining poised to capitalize when conditions improve. A balanced approach keeps companies flexible and resilient.