5 Debt Ratios for Business Acquisitions

When evaluating a business for acquisition, understanding debt ratios is critical. These metrics reveal how a company manages its debt and financial risks. Here's a quick summary of the five key debt ratios you need to know:

• Debt-to-Equity Ratio: Measures the balance between debt and equity. A ratio between 1.0 and 1.5 is considered healthy, but this varies by industry.
• Debt-to-Asset Ratio: Shows what percentage of a company's assets are financed by debt. A ratio under 0.5 is typically safer.
• Debt Service Coverage Ratio (DSCR): Indicates whether a company can cover its debt payments with cash flow. A DSCR of at least 1.25 is preferred.
• Debt-to-EBITDA Ratio: Reflects how many years it would take to repay debt using earnings. Ratios below 3.0 are low-risk, while anything above 5.0 raises concerns.
• Interest Coverage Ratio (ICR): Assesses how well a company can cover interest payments. A ratio above 2.0 is generally acceptable, with 3.0 or higher being ideal.

These ratios help you assess financial health, identify risks, and plan for post-acquisition financing. Always compare these metrics to industry standards for context.

1. Debt-to-Equity Ratio

Formula and Calculation

The debt-to-equity ratio is a straightforward calculation: divide a company's total liabilities by its total shareholders' equity. The formula looks like this:

Debt-to-Equity Ratio = Total Liabilities ÷ Total Shareholders' Equity

Both numbers can be found on a company's balance sheet. Total liabilities represent the company's debts, while shareholders' equity reflects the net assets.

For instance, in Q1 2024 (ending December 30, 2023), Apple Inc. reported $279 billion in total liabilities and $74 billion in total shareholders' equity. This results in a debt-to-equity ratio of 3.77.

What It Measures

This ratio highlights how much a company relies on debt compared to equity for its financing. A higher ratio suggests the company leans more on borrowed funds, which could signal increased financial risk. On the flip side, a lower ratio indicates the company is primarily using its own capital to fund operations. The ideal ratio often depends on the industry, as we'll explore below.

Typical Healthy Range

A debt-to-equity ratio between 1.0 and 1.5 is often seen as balanced. Ratios above 2.0 might raise concerns about financial stability. However, these benchmarks vary widely across industries. For example, capital-heavy sectors like manufacturing or utilities typically operate with higher ratios compared to industries like technology.

Industry	Average Debt-to-Equity Ratio
Biotechnology	0.17
Computer Hardware	0.35
Aerospace & Defense	0.46
Airlines	1.29
Auto & Truck Dealerships	2.12
REIT - Mortgage	2.53
Resorts & Casinos	2.70

Studies show that companies with ratios above 2.0 are 35% more likely to face financial trouble within five years compared to those with ratios under 1.0. Additionally, businesses maintaining ratios between 0.5 and 1.5 tend to enjoy, on average, 12% higher price-to-earnings ratios.

Relevance for Business Acquisitions

When assessing a potential acquisition, the debt-to-equity ratio becomes a key tool for evaluating financial risk. It sheds light on how a company funds its operations and whether its financial structure aligns with industry norms. Comparing the ratio to industry benchmarks can help identify potential risks or opportunities.

While a higher ratio might indicate aggressive growth strategies if managed well, companies with ratios below 1.5 are 25% more likely to secure loan approvals. This makes the metric especially important for planning post-acquisition financing. Lenders often use this ratio to evaluate creditworthiness, so keeping it in check can smooth the path for funding after the deal closes.

2. Debt-to-Asset Ratio

Formula and Calculation

The debt-to-asset ratio is calculated by dividing a company's total liabilities by its total assets. It reflects the portion of a company's assets financed through debt.

Debt-to-Asset Ratio = Total Liabilities ÷ Total Assets

Both numbers are taken directly from the company’s balance sheet. Total liabilities include all short-term and long-term debts, while total assets represent everything the company owns - ranging from tangible items like equipment and buildings to intangible assets such as patents and trademarks. The result is typically shown as a decimal or percentage. Similar to the debt-to-equity ratio, this metric provides a snapshot of a company’s financial structure.

For instance, in March 2024, Bajaj Auto Limited reported total liabilities of ₹13,937 crore and total assets of ₹44,538 crore. This gives a debt-to-asset ratio of 0.31, meaning that 31% of the company’s assets are financed through debt.

What It Measures

This ratio reveals how much of a company’s assets are funded by debt. A ratio of 0.5, for example, means half of the company’s assets are financed through borrowing, while the other half is funded by equity.

A ratio closer to 1.0 suggests a heavy reliance on debt, which could pose financial risks. On the other hand, a very low ratio might indicate a company is not taking full advantage of borrowing to fuel growth.

Typical Healthy Range

A debt-to-asset ratio under 0.5 is often considered a healthy benchmark, with many experts recommending an ideal range between 0.3 and 0.5. Companies with ratios above 50% are generally at a higher risk of financial distress, whereas those below 0.5 are 40% more likely to secure loan approvals.

Industry norms play a huge role here. Manufacturing companies, which are more capital-intensive, typically show debt-to-asset ratios about 20% higher than technology firms. Meanwhile, retail businesses often have much higher ratios, averaging around 249% . Knowing these variations is key to understanding how leverage impacts different sectors, particularly during acquisitions.

Relevance for Business Acquisitions

When evaluating a potential acquisition, the debt-to-asset ratio offers valuable insight into the target company’s financial leverage and risk profile. It helps buyers determine how the business funds its operations and whether its debt levels align with industry norms. A higher-than-average ratio may indicate aggressive borrowing, which could be a red flag for financial stability. Conversely, a much lower ratio might suggest conservative management or untapped growth potential through strategic borrowing.

"Leverage can be an interesting option for a company since it can enable growth. But it must be used wisely."

• Florence Bessette, CPA, Business Advisor, BDC Advisory Services

This ratio also plays a role in shaping post-acquisition financing strategies. Companies with moderate leverage - typically between 30% and 60% - strike a balance between growth and risk management. Such businesses are often more appealing to lenders and offer flexibility for future capital needs. Buyers should also examine trends in the ratio over time to gauge whether the target company has been increasing or reducing its reliance on debt. These trends can reveal important insights about management’s financial discipline and strategic priorities.

3. Debt Service Coverage Ratio (DSCR)

Formula and Calculation

The Debt Service Coverage Ratio (DSCR) is a critical metric for evaluating a company's ability to meet its current debt obligations using its operating cash flow. The standard formula is:

DSCR = Net Operating Income ÷ Total Debt Service

Some lenders, however, prefer an EBITDA-based approach:

DSCR = EBITDA ÷ (Principal + Interest + Cash Taxes).

Here’s how the components break down:

• Net Operating Income: This is revenue after deducting operating expenses.
• Total Debt Service: Includes all current debt payments, such as interest, principal, sinking funds, and lease payments.

This calculation complements other debt ratios by focusing specifically on how operational cash flow measures up against debt obligations. For instance, if a company has a net operating income of $100,000 and total debt service of $60,000, its DSCR would be approximately 1.67.

What It Measures

DSCR evaluates whether a company’s cash flow is sufficient to cover its debt payments. A ratio of 1.00 means operating income just meets debt service requirements. Anything below 1.00 signals potential cash flow issues.

"Debt service coverage ratio is a basic indicator of your company's financial health and one that all entrepreneurs should be familiar with."

• Alka Sood, Consultant, BDC Advisory Services

This metric is particularly valuable because it accounts for both the interest and principal payments, offering a well-rounded view of debt repayment capacity.

Typical Healthy Range

Lenders often require a minimum DSCR between 1.2 and 1.25, though some, like commercial banks and equipment financing firms, may look for ratios closer to 2.0 or higher. For Small Business Administration (SBA) loans, the minimum DSCR is typically 1.25, although some lenders might accept as low as 1.15 if there are strong mitigating factors.

DSCR Value	Interpretation	Risk Level
< 1.0	Insufficient cash flow	High risk
1.0	Break-even	Risky
1.15–1.25	Minimum for most SBA loans	Acceptable
1.5	Good	Low risk
2.0+	Excellent	Very low risk

A DSCR above 1.25–1.5 provides a comfortable safety margin. For example, a DSCR of 1.25 means the business could withstand a 20% drop in earnings before struggling to meet payments, while a DSCR of 1.5 allows for a 30% decline without defaulting.

Relevance for Business Acquisitions

DSCR plays a pivotal role in evaluating cash flow sufficiency, especially when assessing the feasibility of new debt loads in acquisition scenarios. Like debt-to-equity and debt-to-asset ratios, it provides a measure of financial stability, but with a focus on cash flow's ability to handle debt payments.

Lenders rely on DSCR to determine whether a business can manage the extra debt required for an acquisition. A strong DSCR signals lower risk of default, which can result in better loan terms. On the other hand, if the target company’s DSCR falls below lender thresholds, buyers might need to:

• Negotiate a lower purchase price.
• Add more cash to the deal.
• Defer seller financing.
• Reassess discretionary earnings assumptions.

Post-acquisition strategies to improve DSCR include:

• Boosting revenue.
• Cutting operating expenses.
• Refinancing existing debt at better rates.
• Paying down principal balances.

A consistently strong DSCR indicates a business with reliable cash flow and disciplined financial management. For buyers, this translates to reduced acquisition risk and smoother operations after the purchase. When used alongside other financial ratios, DSCR provides a well-rounded framework for assessing the financial health of an acquisition target.

4. Debt-to-EBITDA Ratio

Formula and Calculation

The Debt-to-EBITDA ratio measures how many years it would take for a company to repay its debt using its current earnings. The formula is:

Debt-to-EBITDA Ratio = Total Debt ÷ EBITDA

Let’s break down the components (based on):

• Total Debt: This includes all interest-bearing liabilities, both short-term and long-term. Examples include business loans, credit lines, and bonds.
• EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s typically calculated by adding back interest, taxes, depreciation, and amortization to net income.

Here’s an example:
If Company ABC has an EBITDA of $10 million and total debt of $30 million, the ratio would be 30 ÷ 10 = 3.0. This means it would take about three years to repay the debt at the current earnings level. On the other hand, if Company XYZ has the same $10 million EBITDA but $60 million in debt, its ratio would be 60 ÷ 10 = 6.0, indicating a much longer repayment timeline.

What It Measures

This ratio provides insight into a company’s ability to handle its debt load using operational cash flow. By focusing on earnings before non-cash expenses, it highlights how efficiently a company can service its debt.

Typical Healthy Range

The acceptable range for this ratio depends on the industry, but general guidelines are as follows:

Ratio Range	Risk Assessment	Financing Impact
Below 3.0	Low risk	Easier access to financing
3.0 – 5.0	Moderate risk	Potential restrictions on financing
Above 5.0	High risk	Challenging to secure additional debt

A ratio below 3.0 is considered low-risk and indicates financial health. Ratios between 3.0 and 5.0 suggest moderate risk, while anything above 5.0 signals possible financial distress. For context, the average net debt-to-EBITDA ratio for S&P 500 companies is about 1.3, and leveraged buyout loans typically stay below 5.0 (as of Q1 2023).

Relevance for Business Acquisitions

When evaluating potential acquisitions, the debt-to-EBITDA ratio is a key metric for understanding a target company’s ability to manage additional debt from the transaction. A high ratio can make a deal less appealing, as it indicates potential difficulties in repaying both existing and new debt.

Buyers often compare the target company’s ratio to industry peers to gauge its financial health and profitability. Lenders may also set specific debt-to-EBITDA thresholds in loan agreements to avoid triggering accelerated repayment clauses. If the ratio is too high, buyers might need to consider options like equity injections, adjustments to seller financing, or negotiating a lower purchase price.

This metric complements other financial indicators by focusing on the company’s operational ability to service its debt, offering a clearer picture of its financial stability.

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5. Interest Coverage Ratio

Formula and Calculation

The Interest Coverage Ratio (ICR) gauges how well a company can cover its interest payments using its earnings. It’s calculated by dividing EBIT (Earnings Before Interest and Taxes) by Interest Expense:

Interest Coverage Ratio = EBIT ÷ Interest Expense

To calculate EBIT, you simply add Interest and Taxes back to Net Income.

Some analysts prefer using EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) for a broader perspective:

Interest Coverage Ratio = EBITDA ÷ Interest Expense.

For example, if a construction company reports a net income of $48,000, a tax expense of $12,000, and an interest expense of $40,000, its ICR would be 2.5. In comparison, a larger company might have a much higher ratio.

What It Measures

The Interest Coverage Ratio reflects how comfortably a business can meet its interest obligations using its current earnings. A higher ratio suggests the company is in a stronger financial position to handle debt payments, while a lower ratio indicates vulnerability, as less profit is available to cover interest costs. This metric is particularly important for lenders and investors because it showcases a company’s operational ability to manage debt.

Typical Healthy Range

Here’s a quick reference table for interpreting ICR values:

Ratio Range	Financial Health	Industry Considerations
Below 1.0	Poor – Unable to cover interest payments	Major concern across industries
1.0 – 1.5	Concerning – Barely sufficient coverage	Requires close monitoring
2.0 – 3.0	Acceptable – Adequate coverage	Minimum for most industries
Above 3.0	Strong – Comfortable coverage	Ideal for capital-heavy sectors

An ICR below 1.0 is a clear warning sign that the company doesn’t generate enough earnings to cover its interest payments. Generally, a ratio of at least 2.0 is considered the baseline for companies with steady revenue streams. However, in some industries, a ratio of 3.0 or more might be the standard. For instance, manufacturing companies often aim for an ICR around 3.0 due to their higher capital needs, while technology firms with less debt can operate comfortably with a ratio closer to 2.0. Across the nonfinancial corporate sector, the average ICR is approximately 3.7, though about one-third of companies report ratios under 2.0.

Relevance for Business Acquisitions

The Interest Coverage Ratio is a key metric when evaluating a company for acquisition. It helps assess whether the target can manage its current debt and any additional financing that might result from the deal. A strong ICR indicates a lower risk of financial difficulties, while a weak ratio could signal the need for further investigation or adjustments in the transaction structure.

For instance, Omega Manufacturing, with an EBITDA of $2 million and annual interest expenses of $200,000, has an EBITDA/Interest Coverage Ratio of 10. This makes it an appealing acquisition target due to its strong debt management. On the other hand, Beta Tech, with an EBITDA/Interest Coverage Ratio of just 1.5, raised concerns among potential investors due to its tighter financial situation.

Buyers should compare the target company’s ICR to industry benchmarks and consider how acquisition financing might impact this ratio. A weak ICR might require strategies like equity injections or debt restructuring to secure financial stability after the deal.

For a more streamlined analysis of these metrics, tools like Clearly Acquired (https://clearlyacquired.com) can help buyers make well-informed decisions during the acquisition process.

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Quick Reference Table

This table provides a concise overview of five key debt ratios, summarizing their formulas, what they measure, healthy ranges, and insights for acquisitions. It’s a handy resource for transitioning from detailed analysis to a quick-reference format.

Debt Ratio	Formula	What It Measures	Healthy Range	Acquisition Insights
Debt-to-Equity Ratio	Total Debt ÷ Total Equity	Financial leverage and reliance on debt vs. equity financing	1.0–1.5	Ratios above this range may signal increased financing risk.
Debt-to-Asset Ratio	Total Debt ÷ Total Assets	Percentage of assets financed through debt	Typically 0.3–0.5	Industry-specific comparisons are essential to contextualize this ratio.
Debt Service Coverage Ratio (DSCR)	Net Operating Income ÷ Total Debt Service	Ability to cover debt payments using operating cash flow	Minimum 1.25; conservative lenders prefer 1.5 or higher	A DSCR of 1.25 means earnings can drop 20% before payments are missed; at 1.5, earnings could fall 30%.
Debt-to-EBITDA Ratio	Total Debt ÷ EBITDA	Years needed to repay debt using EBITDA	Below 3.0× is acceptable; 5.0× or higher raises concerns	Indicates how long it would take to repay debt if all EBITDA were allocated to repayment.
Interest Coverage Ratio	EBIT ÷ Interest Expense	Ability to meet interest obligations from earnings	Generally above 1.0; industry average is around 3.7	Ratios below the industry average may require further investigation.

Key Statistics for Context

• Nearly 70% of small employer firms carry outstanding debt, with 61% holding balances of $100,000 or less.
• Approximately one-third of companies report Interest Coverage Ratios under 2.0, while the corporate average is closer to 3.7.

When assessing acquisition targets, it’s crucial to evaluate these ratios collectively rather than in isolation. For example, a strong interest coverage ratio might look promising, but a high Debt-to-EBITDA ratio could expose risks related to repayment timelines or debt structure. Benchmarking these metrics against industry norms can help identify both potential red flags and opportunities.

"Financial ratios give you that", says Stéphanie Bourret, Senior Manager, Underwriting at BDC.

Conclusion

Understanding and applying these five debt ratios can significantly enhance your ability to make informed acquisition decisions. These metrics offer a clear picture of a company's financial health, stability, and risk level - key factors that directly impact your ability to negotiate better terms and secure the right financing options.

Interestingly, only 15% of companies excel at fully leveraging financial ratios in their decision-making process. For buyers who take the time to master these metrics, this presents a unique opportunity to gain a competitive advantage.

"As a key indicator of financial stability and risk, your debt ratio shows how much of your business assets are funded by debt. This is critical to know as it affects your future borrowing abilities." - Allianz Trade

Debt ratios serve as a critical benchmark. Ratios below 0.4 suggest a healthy balance between liabilities and equity, while those above 0.6 may indicate overleveraging, which could limit future borrowing potential. However, these figures are most meaningful when compared against industry standards, historical trends, and competitor data for a well-rounded evaluation.

These insights tie directly into the broader analysis provided earlier, emphasizing the importance of these metrics in the acquisition process. After evaluating debt ratios, it’s essential to conduct comprehensive due diligence to assess every aspect of the target business.

For those navigating acquisitions, Clearly Acquired offers a streamlined approach with integrated capital solutions, expert advisory services, and AI-powered tools. From SBA loans and commercial financing to equity solutions, these resources are designed to help you analyze deals effectively and secure the ideal capital structure for your goals.

FAQs

Why are industry benchmarks important when analyzing debt ratios during a business acquisition?

Industry benchmarks play a key role in evaluating debt ratios, as they offer a frame of reference for what constitutes a reasonable or risky level of debt within a particular sector. For example, a debt-to-equity ratio that might raise red flags in one industry could be entirely standard in another. Comparing a company’s metrics, such as debt-to-assets or debt-to-equity, against these benchmarks allows buyers to assess if the company’s financial leverage is within a typical range or leaning toward the excessive side.

Relying on these benchmarks enables buyers to make better-informed decisions, ensuring the company’s debt levels are consistent with industry expectations. This approach minimizes the risk of taking on too much debt and helps establish a fair valuation during the acquisition process.

What are some effective ways to improve a company's debt service coverage ratio (DSCR) after acquiring it?

Improving a company's debt service coverage ratio (DSCR) after an acquisition is a smart move to boost financial stability and appeal to lenders. Here’s how businesses can achieve that:

• Boost net operating income (NOI): Increase revenue by enhancing sales efforts, refining marketing strategies, or upgrading products. At the same time, trim unnecessary expenses to improve profitability.
• Refinance debt: Explore opportunities to lower interest rates or extend loan terms, which can ease monthly debt obligations.
• Pay down debt: Use available cash flow to tackle high-interest or short-term debts, reducing overall financial strain.

Beyond these steps, managing cash flow effectively, eliminating non-essential costs, and streamlining operations can further strengthen the DSCR. A strong DSCR not only improves financial flexibility but also positions the business better for future funding and investment opportunities.

Why is it important to evaluate multiple debt ratios together when assessing a business acquisition?

Evaluating several debt ratios together gives a clearer picture of a company's overall financial standing, including its leverage, risk levels, and long-term stability. Each ratio sheds light on specific areas like liquidity, how well debt is managed, and how efficiently assets are being used. Looking at just one ratio might leave gaps, but combining them offers a more complete view.

When these ratios are analyzed as a group, potential buyers can assess whether the business is capable of managing its debt, maintaining operations, and generating value post-acquisition. This thorough approach reduces the chances of unexpected financial issues and supports making a well-informed investment choice.