As a business owner or managerial figure in the corporate finance world, it can be difficult to determine if your company has a positive profit outlook if you aren’t considering long-term debt ratios.
These numbers reflect an entity’s overall financial health by comparing its assets to its loans, bonds and other debt obligations. Corporate accountants typically will include only loans that will not be paid off in the short term (a year or less). The smaller the long-term debt ratio, the better standing the company is in.
The answer can be explained by walking through the long-term debt formula and understanding what it means.
Calculating a Long-term Debt Ratio
Your business’s long-term debt ratio is found by dividing your long-term debts over your total assets. If there are any assets that are financed by a portion of that debt, both values are canceled out.
Here’s a visual of what we’re talking about:
Long-term debt = (Long-term debt)/(Total assets)
This calculation also stacks your other debts against assets that the company owns, or isn’t indebted to someone for.
(You can also check out some online calculators).
The long-term debt ratio should never be greater than one because that would tell you that the value of debt was greater than the value of assets. Obviously, owing more than what you are worth is never a good thing.
On the reverse, the closer the ratio is to zero, the greater the divisor (the divisor is the “divided by” number which, in this case, is your total asset amount). When a company has far more assets than it does in debt, they’re in a better position financially.
What do You Know From Finding the Long-term Debt Ratio?
Once you’ve found your company’s long-term debt ratio, you now know what portion of its assets your business would need to liquidate to repay its long-term debt. This is a good value to always have on hand when considering large financial decisions, like taking on a new loan or refinancing debts through a new institution.
When approaching a lender for a new loan, however, the underwriters often determine how much money the company can borrow without over-leveraging its long-term debt ratio. While it’s easy to assume that loaners want to shell out as much money as possible to maximize profits off of interest accruals, that’s not necessarily the case.
If a lender were to loan a business more money than it is capable of repaying, the company is more vulnerable to financial consequences such as default, foreclosure or even bankruptcy. At this point, the business may stop paying the loan altogether, bringing the institution’s interest profits to an end.
For this reason, lenders like to have your current long-term debt ratio on hand to know how much of an impact on that value they’re comfortable making.
A good long-term debt ratio varies depending on the type of company and what industry it’s in but, generally speaking, a healthy ratio would be, at maximum, 0.5. Or, to put that another way, the company would need to use half of its total assets to repay every penny of its debts at any given time.
It’s considered good business practice to keep an eye on this ratio in the event of a bankruptcy or sudden dissolvement, perhaps due to the death or otherwise incapacitation of a controlling individual. A company should always strive to not be indebted more than half of what its assets are worth should it ever need to immediately sell all assets and break even with debts.
If a company has too much debt to break even after selling assets, it will remain in the hole even after declaring bankruptcy.
Why is My Company’s Long-term Debt Ratio Going Down?
If you were to plot any sequence of values on a line graph, it might be alarming to see a downward slope out of habit. A number series that gets bigger should indicate profit, just as one that is getting smaller would be a sign of loss, right?
The good news is that that’s not the case with a consecutive cluster of long-term debt ratios. If your company’s ratio is going down, then the number on the top of that equation is steadily getting smaller.
After talking about the formula of long-term debt, we know that this means your company has been paying off its debts faster than it has been accruing them.
However, paying down debts isn’t the only culprit behind a declining long-term debt ratio.
Decreasing Ratios When Debt Isn’t Being Paid Off
Rather than the top number of our equation—the total debts—getting smaller, the bottom number—the total assets—could be getting bigger.
Your company could be using other means of generating growth, such as charitable donations or grants.
While these cases are not as common as paying down debts, your company could have received, or be steadily receiving, large donations of cash or capital, or otherwise somehow acquiring it without purchasing it, that is increasing its total assets without increasing its debt.
This is frequently possible when a business or individual has an investment account that they consider part of their total assets. If the account generates a profit off of the state of the stock market, the total asset number goes up, because the investment account has more money than the last time the long-term debt ratio was calculated.
The more likely cause, however, is that your corporation is making smart money moves and paying off what it owes, and who isn’t happy to have less debt?
Why is My Company’s Long-term Debt Ratio Going Up?
By this point, you probably know the unfortunate truth of what it means when your long-term debt ratio is going up. The simple answer is that your corporation has accrued more debt, whether through accumulated interest on loans, financing more projects or capital like equipment or real estate, or somehow losing an asset that was financed in the first place.
For example, say you own a construction company and purchase a used truck with a $20,000 loan. Just a few months later, the truck’s engine dies and leaves you no choice but to sell it at a massive loss. You may get $5,000 out of the decommissioned vehicle, but you’re still indebted $15,000 for something that you can’t even use anymore.
This is an instance in which your long-term debt ratio would go up, not because of an increase of debt, but a loss of capital. While these circumstances are typically unpredictable, most companies are vulnerable to them.
Tracking Company Behaviors
Typically, a steady increase in a business’s long-term debt ratio can reveal a lot about its spending habits.
If your company has, for whatever reason, not been paying its monthly dues on its loans, the gathering interest can also increase the top value in our long-term debt formula.
Financing new capital and quickly reselling for less than what it was purchased for can grow this value, too. This can happen when a company frequently buys brand-new equipment and sells it soon after, with a massive depreciation against the value just from being taken off the lot or out of the factory.
Poor hiring, training, and staff retention practices may also be the root of the cause of a rising long-term debt ratio. The workforce behind a company is considered capital just as much as machinery, land, and money are.
Bringing new people onto a team is a costly venture, and if the employees are subpar, the training process insufficient, or the job description misleading, the money funneled into a new hire is immediately considered a loss.
As the overseer of your company’s finances, it would be wise to raise the alarm if you find that the long-term debt ratio is getting to .45-.47, which would allow the business time to correct their financial status accordingly before surpassing the maximum comfortable ratio of 0.5.
Temporarily Raising the Long-term Debt Ratio on Purpose
It goes without saying that a corporation only makes a large purchase if it intends on profiting or benefiting from the buy-in some way. Those benefits, however, are not always immediately available.
There can be instances in which a company finances new capital, knowing the impacts it will have on its long-term debt ratio, but hopes that an eventual profit will bring the ratio back down in the long term.
For example, a small insurance business may decide to purchase a second office space to open another location across town. For a time, this will have significant impacts on its debt ratio, but the company plans to eventually profit off of the second location’s new customers enough to bring the ratio back down.
This can negate the belief that long-term debt ratios are always better when they are lower. Sometimes, a company has to weigh the risks of increasing that ratio in order to profit off of a new venture.
Why Should I Bring Down My Long-term Debt Ratio?
Besides wanting your company to be financially stable in the future, it’s good to lower this value if your business is looking to approach investors anytime soon.
Potential investors are well aware of what a long-term debt ratio is, and are generally unsettled by companies with high ones. Investors, be it financial institutions or private individuals, want to be confident in a company’s financial stability before they back it with their own money.
However, investors are also complex people who have different goals and preferences. Certain individuals and groups may react adversely to any amount of risk factor, such as those who offer the most competitive interest rates and loan terms. Other investors with a higher tolerance for risk may not scrutinize your debt ratio that much at all.
Keeping this value down also gives you an idea of how prepared your company may be for any unforeseen circumstances in the future that may require opening up another loan.
Debt Ratios in Bear vs. Bull Markets
In a bear market environment (a market where prices are falling, which encourages selling), the ring of investing becomes much more competitive. Faced with many more options to choose from, investors are going to hone in on the companies with the least total debt.
Buyers look at companies’ debt ratios differently in a bull market; however, where the power is shifted to purchasers rather than sellers. In this environment, investors like to see companies that can provide a higher margin of growth.
Using the Long-term Debt Ratio to Your Advantage
You now know that what appears as just a simple number is much more complex. If you could only take a few takeaways from this guide through long-term debt ratios, these are the most important:
- Your company’s ratio should never be one or greater. This means that the business is in debt more than it’s worth.
- A long-term debt ratio of 0.5 or less is a broad standard of what is healthy, although that number can vary by the industry.
- The ratio, converted into a percent, reflects how much of your business’s assets would need to be sold or surrendered to remedy all debts at any given time.
- A decreasing long-term debt ratio typically means paying off debt, but not always.
- Reversely, an increasing ratio means taking on more debt, but could also mean a sudden loss of capital.
There are always unique circumstances and goals for each business that come into play when considering what your long-term debt ratio means.
Before making any major financial decisions, like taking on a new loan, buying real estate, increasing staff or setting other growth goals, you’ll want to talk to a corporate accountant or financial analyst to find out what you can afford for risk.