Debt Ratios: How Much Borrowing Is Too Much

Borrowing is not a defect. Debt is generally cheaper than equity, interest is usually tax deductible, and a business that can earn more on borrowed money than the money costs is doing something rational. The question is never whether a company has debt. It is whether the debt fits the business.

Three ratios get used most, and they answer genuinely different questions.

Debt to equity: the structure question

Total debt divided by shareholders equity. It describes how the asset base was funded, by lenders or by owners.

Its main weakness is that equity is a balance sheet figure, and balance sheet equity is a residual produced by accounting conventions rather than a market value. A company that has bought back a lot of its own shares can show very low or even negative equity while being entirely sound, because buybacks reduce the equity line directly. The ratio can therefore look alarming for structural reasons that have nothing to do with the ability to service borrowing.

Net debt to EBITDA: the capacity question

Total debt minus cash, divided by earnings before interest, tax, depreciation and amortisation. Read loosely, it approximates how many years of operating earnings the borrowing represents.

This is the ratio lenders themselves tend to use, and it appears in loan covenants, which makes it the one with real consequences attached. Breaching a covenant threshold can trigger renegotiation on worse terms, at exactly the moment the company can least afford it.

The caution is that EBITDA excludes real costs. Depreciation is not a cash payment this year, but the assets it represents do eventually need replacing, and a business with heavy ongoing capital requirements looks better on EBITDA than its actual cash position warrants. Reading it beside free cash flow corrects for most of that.

Interest cover: the immediate question

Operating profit divided by interest expense. How many times over current earnings cover the current interest bill.

This is the most direct measure of near term pressure and the easiest to interpret. Cover of ten means interest is a minor line. Cover of one and a half means most of the operating profit is going to lenders and there is little room for a bad quarter.

It is also the ratio that moves fastest when rates change, because refinancing at a higher rate raises the denominator without anything happening to the business.

Why the industry is the whole context

Comparing debt ratios across industries produces conclusions that are simply wrong.

A regulated utility with predictable, contracted revenue can carry borrowing that would be reckless for a software company with volatile revenue and no physical assets to lend against. Property companies are borrowing to own income producing assets, and their ratios reflect the asset rather than fragility. Banks operate on a balance sheet structure where the usual ratios do not apply in any comparable sense at all.

The only useful comparison is against direct competitors and against the same company's own history. Cross industry comparison is not a stricter test, it is a meaningless one.

The thing the ratios miss

None of the three says when the money is due, and the maturity schedule is frequently the deciding factor.

Two companies with identical ratios are in entirely different positions if one has its borrowing spread evenly over ten years and the other has all of it maturing in fourteen months. The second has to refinance, at whatever rates and conditions exist on that date, and it has no choice about the timing.

Whether the debt is fixed or floating rate matters for the same reason. Floating rate borrowing reprices with the market, so the interest bill can rise substantially without the company doing anything.

Both of these are disclosed in the notes to the accounts, and neither shows up in any headline ratio.

Off balance sheet obligations

Lease accounting rules changed to bring most leases onto the balance sheet, which improved comparability considerably. Other commitments still sit in the notes: pension deficits, purchase obligations, guarantees. These are real claims on future cash and they do not appear in a debt to equity figure taken from a data provider.

Borrowing in the wider picture

Balance sheet strength is one input to the fundamentals reading EquityBias produces per covered stock, alongside price behaviour, analyst activity and news sentiment. A company whose fundamentals are deteriorating while its share price holds up produces a wide gap between those readings, and that gap is reported as divergence rather than averaged away. Related: what is fundamental analysis. Current readings by sector are in the coverage directory.

EquityBias is a market data research tool. Nothing here is financial advice. Financial statement figures are historical and do not indicate future performance.