Debt Ratio

Debt can be dangerous for a company. The ability to borrow money is key to building a business. In some ways, it's the life blood of growth. But too much can make it difficult to survive, as the debt becomes expensive to service and potentially makes a company vulnerable.

Think of it like caffeine. A little bit fuels a productive morning. But setting up a Red Bull I.V. will likely trigger heart palpitations and a lengthy stay in a rehab facility.

But how much debt is too much?

It depends on the situation, but a key statistic to look at is the debt ratio. This compares the amount of debt the company has versus the amount of assets. Another way to put it: the stat provides a look at how much debt a company has as a proportion to how much stuff it has. A high debt ratio can indicate that a business has become over-leveraged and might face a credit crunch in the wrong circumstances.

Whatever.com has $50 million of 6% debt costing 3 mil a year to service. If whatever.com had 40 million in cash profits, servicing its debt would be easy...and it would have a debt service ratio of 40 over 3, or 13 ⅓ x coverage.

Said another way, the odds that whatever.com would find itself in a position that it couldn’t service its debt are very low. But think about the other side of the coin. If whatever.com had only 4 million in cash profits, then its debt service ratio is 4 over 3…meaning that 75% of its cash flow leaves the company and goes into the coffers of the kindly, loving lenders who are nervous about the company falling into default.

Which, uh…does not make the oil go down easy.