Debt Ratios and Why They Matter to Small Businesses

Both small business lenders and business credit rating agencies like Dun & Bradstreet look at debt ratios because:

• The ratios indicate how much of your total business value you already owe to other creditors.
• They show how likely you are to make payments when repaying a loan.
• Together, they tell a story about how you have managed your business and how well you have used previous loans to grow your business.

The lower the percentage, the better your numbers are. This shows lenders you can turn investments into profit and will have no problem repaying their loans in full. However, if your number is higher than that of a friend who also owns a small business, don’t worry.

Debt ratios vary by industry, as this NYU Professor shares in a table with percentages from the beverage industry to the homebuilding, real estate, and retail industries. This is why you’ll want to compare your company to others in the same industry when analyzing your business’s health before submitting a loan application.

Pro-tip: The Census bureau’s economic census and quarterly financial report offer numbers you’ll need (broken down by NAICS code) to calculate debt ratios for your sector and industry peers, so you can see how your figures compare.

Now let’s take a look at 7 different debt ratios and why they all matter for your small business.

Current Ratio and Quick Ratio

The current ratio and quick ratio (also called “acid test” ratio) both measure your ability to cover short-term debt (due within 1 year). That’s why lenders might look at them extra closely for shorter-term loans like inventory financing or working capital loans.

A higher figure is better for these ratios to show you aren’t a near-term default risk. However, while both ratios are similar, use the quick ratio to make sure you’re covered in case of emergencies, since it focuses on things that can “quickly” become cash.

All the numbers you need for these ratios come from your balance sheet.

Debt to Equity and Debt to Capital Ratio

Debt to equity and debt to capital both show how much you owe to creditors vs. how much you’d keep if you sold all business assets today. Lenders like lower numbers that show you don’t have too many claims on your assets from other creditors.

If a worst-case situation happens, you can sell off your assets to fully repay banks and other creditors. When these ratios go down over time, it usually means you’re growing earnings faster than debt and that you’re a relatively low-risk business for a lender.

Debt to Assets Ratio

The debt to assets ratio shows the percent of your total business value that you owe to creditors. Some lenders prefer when this ratio goes down over time to see that you’re building equity in your business, similar to how you build equity in a house.

On the other hand, if this ratio keeps going up, lenders may assume you’re not doing a good job of converting previous loans or credit into income and might not want to risk lending you money.

Here’s an example. Imagine you started with $150,000 in total liabilities (debt) and $170,000 in assets.

• Your debt to assets ratio is total liabilities / total assets = $150,000 / $170,000 = 88%.

If you ask a bank to loan you $30,000, you would add that amount to your total debt and also to your total assets (in cash). You would now have $180,000 in total liabilities (debt) and $200,000 in assets.

• Your new debt to assets ratio would be $180,000 / $200,000 = 90%.

This might cause some concern for the bank, because when this number goes over 100%, it means you owe more than your assets can cover, like being underwater on a mortgage.

Interest Coverage Ratio

Lenders will pay close attention to interest coverage, because it shows that you can at least pay the interest on your debt, which is how lenders make their money. A growing interest coverage ratio over time is a good indicator that you can continue to cover interest payments, even if you run into a slight slowdown in the future.

This ratio is important for variable-rate loans since the lender wants to make sure you’re able to pay interest if your rate increases. You’ll find the numbers to calculate your own interest coverage ratio on your income statement.

Pro-tip: Most accounting software has an automated report for this. Quickbooks calls your income statement the “Profit and Loss” report. You can create a “calculated field” to sum up Net Income + Interest Expense + Tax Expense so that you don’t have to do it manually each time, and you can add that field to a “custom” Profit and Loss report, allowing you to easily track this ratio over time.

Debt Service Coverage Ratio

The debt service coverage ratio shows lenders that you have plenty of cash flow to cover both the principal and interest payments on loans. If this ratio drops below 1, banks will be extra cautious since you might not have enough cash flow to pay back the full loan plus interest.

Lenders will also want to see this ratio growing over time, as it shows you are capable of turning investments into cash flow, making you a less risky borrower to lend to.

You can use either formula below to calculate it for yourself. They both give you the same number, but one might be quicker depending on how your accountant or accounting software formats your financial statements.

Now you know how to figure out 7 key debt ratios for your small business and why they matter to lenders when you want a small business loan.