How Debt Impacts a Company

How Debt Impacts a Company

The amount of debt a company takes on has an impact on its balance sheet. In particular, it affects the relationships between several components of the balance sheet. Analysts, investors and bankers all rely to a certain extent on the balance sheet to determine the risk profile of the business. An increase in debt could signal that a company is moving toward shakier financial ground.


Financial ratios are an objective way to represent the relationship of financial statement components with each other. Changes in a company's ratios can indicate to analysts and investors that a company is headed in a particular direction, depending on whether the ratio is improving or declining. Changes in the amount of debt a company has will impact several of these ratios, depending on what the debt is used for. Debt can be used to retire other debt, buy assets or pay expenses.

Debt-to-Asset Ratio

This ratio is calculated by dividing a company's total debt by its total assets. For example, if a company has $10,000 in debt and $20,000 in assets, its debt-to-asset ratio is 0.5:1. If a company increases its debt to buy more assets, the ratio changes, even though the increase is being added to both the numerator and denominator. For example, using the above company, purchasing a $50,000 piece of manufacturing equipment would result in total debt of $60,000 and total assets of $70,000, for a ratio of .86:1. This increase in the debt-to-asset ratio indicates that the company is moving toward not having enough assets to cover its debt. If the debt is taken on to retire other debt or to pay for expenses, the impact on the debt-to-asset ratio is even greater.

Debt-to-Equity Ratio

The debt-to-equity ratio indicates how much of a company's total financing comes from debt and shareholders. This distinction is important because if a company becomes insolvent, debt must be paid off before shareholders can be paid. A company that carries a lot of debt compared with equity is less likely to be able to provide a return to its investors than a less-leveraged company. The ratio is calculated by dividing total debt by total shareholder equity on the balance sheet. Similar to the example in the previous section, an increase in the amount of debt results in a degradation of this ratio, regardless of how the debt is used.

Dangers of Corporate Debt

For a company, debt equals leverage. In many cases, leverage is an important tool to help a company expand and grow. The more debt a company has, however, the less able it is to make changes to its strategy or operations because lenders often place restrictions on companies. If interest and principal payments are not made as per the contract, a company can face losing its assets or even facing bankruptcy. Monitoring balance sheet ratios is a critical tool for a company to assess its leverage.


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