How Investors Use Leverage Ratios to Gauge Financial Health

While some businesses are proud to be debt-free, most companies have, at some time, borrowed money to buy equipment, build new offices, and/or issue payroll checks. For the investor, the challenge is determining whether the organization’s debt level is sustainable.

Is having debt harmful? In some cases, borrowing may be a positive indicator of a company's health. Consider a company that wants to build a new plant because of increased demand for its products. It may have to take out a loan or sell bonds to pay for the construction and equipment costs; however, its future sales are expected to be more than the associated costs. And because interest expenses are tax-deductible, debt can be a cheaper way to increase assets than equity.

The problem is when the use of debt, also known as leveraging, becomes excessive. With interest payments taking a large chunk out of top-line sales, a company will have less cash to fund marketing, research and development, and other important investments.

Large debt loads can make businesses particularly vulnerable during an economic downturn. If the corporation struggles to make regular interest payments, investors are likely to lose confidence and bid down the share price. In more extreme cases, the company may become insolvent.

For these reasons, seasoned investors scrutinize the company's liabilities before purchasing corporate stock or bonds. Traders have developed a number of ratios that help separate healthy borrowers from those swimming in debt.

Two of the most popular calculations—the debt ratio and debt-to-equity ratio—rely on information readily available on the company’s balance sheet. To determine the debt ratio, simply divide the firm’s total liabilities by its total assets:

A figure of 0.5 or less is ideal. In other words, no more than half of the company’s assets should be financed by debt. In reality, many investors tolerate significantly higher ratios. Capital-intensive industries like heavy manufacturing depend more on debt than service-based firms, and debt ratios in excess of 0.7 are common.

As its name implies, the debt-to-equity ratio, instead, compares the company’s debt to its stockholder equity. It’s calculated as follows:

If you consider the basic accounting equation (Assets – Liabilities = Equity), you may realize that these two equations are really looking at the same thing. In other words, a debt ratio of 0.5 will necessarily mean a debt-to-equity ratio of 1. In both cases, a lower number indicates a company is less dependent on borrowing for its operations.

While both of these ratios can be useful tools, they’re not without shortcomings. For example, both calculations include short-term liabilities in the numerator. Most investors, however, are more interested in long-term debt. For this reason, some traders will substitute “total liabilities” with “long-term liabilities” when crunching the numbers.

In addition, some liabilities may not even appear on the balance sheet and don’t enter into the ratio. Operating leases, commonly used by retailers, are one example. Generally Accepted Accounting Principles (GAAP) doesn’t require companies to report these on the balance sheet, but they do show in the footnotes. Investors who want a more accurate look at debt will want to comb through financial statements for this valuable information.

Perhaps the biggest limitation of the debt and debt-to-equity ratios is that they look at the total amount of borrowing, not the company’s ability to actually service its debt. Some organizations may carry what looks like a significant amount of debt, but they generate enough cash to easily handle interest payments.

Furthermore, not all corporations borrow at the same rate. A company that has never defaulted on its obligations may be able to borrow at a three percent interest rate, while its competitor pays a six percent rate.

To account for these factors, investors often use the interest coverage ratio. Rather than looking at the sum total of debt, the calculation factors in the actual cost of interest payments in relation to operating income (considered one of the best indicators of long-term profit potential). It’s determined with this straightforward formula:

In this case, higher numbers are seen as favorable. In general, a ratio of 3 and above represents a strong ability to pay off debt, although the threshold varies from one industry to another.

To understand why investors often use multiple ways to analyze debt, let’s look at a hypothetical company, Tracy’s Tapestries. The company has assets of $1 million, liabilities of $700,000 and stockholders' equity totaling $300,000. The resulting debt-to-equity ratio of 2.3 might scare off some would-be investors.

Total Liabilities ($700,000) / Stockholders’ Equity ($300,000) = 2.3

A look at the business’ interest coverage, though, gives a decidedly different impression. With annual operating income of $300,000 and yearly interest payments of $80,000, the firm is able to pay creditors on time and have cash left over for other outlays.

Operating Income ($300,000) / Interest Expense ($80,000) = 3.75

Because reliance on debt varies by industry, analysts usually compare debt ratios to those of direct competitors. Comparing the capital structure of a mining equipment company to that of a software developer, for instance, can result in a distorted view of their financial health.

Ratios can also be used to track trends within a particular company. If, for example, interest expenses consistently grow at a faster pace than operating income, it could be a sign of trouble ahead.

While carrying a modest amount of debt is quite common, highly leveraged businesses face serious risks. Large debt payments eat away at revenue and, in severe cases, put the company in jeopardy of default. Active investors use a number of different leverage ratios to get a broad sense of how sustainable a firm’s borrowing practices are. In isolation, each of these basic calculations provides a somewhat limited view of the company’s financial strength. But when used together, a more complete picture emerges—one that helps weed out healthy corporations from those that are dangerously in debt.