What is Target Debt Ratio
There are about 10 different debt ratio metrics that will determine your company’s optimal debt ratio and overall financial health.
They will include:
Cash Flow Coverage
Your ability to pay the interest on the debt you have. Will your Cash Flow each month be high enough to pay your regular expenses, plus the additional interest you are taking on with this debt?
To calculate, take Net Profit, less all other Operational Expenses, including anything on the Balance Sheet; this gives you Operating Cash. Now take Operating Cash, and divide by Interest Expenses minus Interest Income.
Your target is at least two times your Cash Flow over your interest payments. The higher that number is, the better; the minimum would be 2.
Cash Ratio
The availability of your cash/cash equivalents to cover your current liabilities.
Current Liabilities are the amounts of debt due in the next 12 months. This would include Credit Cards, Lines of Credit, and the next 12 months of payments on any Loans you have. You want to make sure that your cash and liquid assets are enough to cover those current liabilities.
To calculate, take your Cash Equivalents divided by your current liabilities.
Your target is 1, but even 0.8 would be good, since this is over the next 12 months, and income can grow, and expenses can be reduced.
Current Ratio
Measurement of liquidity. Rather than focusing on whether you can pay your liabilities, focus on the equity in your business. This is a comparison of your current assets and your current liabilities. The assets you see here include cash, cash equivalents, accounts receivable, and inventory, but not fixed assets. The greater this ratio is, the greater the cushion your company has between your current obligations and your company’s ability to pay them.
To calculate, take your total current assets divided by your total current liabilities.
Your target is 2 or greater.
Quick Ratio
Similar to the Current Ratio, but here the assets you look at would include cash, cash equivalents, accounts receivable, but not inventory.
To calculate, take these current assets divided by your total current liabilities.
Your target is 1 or greater.
Debt to Equity Ratio
Generally, this is the portion of funds you, the owner, have invested in the company, rather than the borrowed debt the company uses to finance its assets. But equity can also include retained earnings and net profit. This ratio can be lower for a new company, and it is also very industry-specific.
To calculate, take your Total Debt divided by your Total Equity, times 100.
Again, your target can vary, but getting below 50% is cause for alarm.
Debt to Free Cash Ratio
Measure of the number of years for your business to repay the total debt from free cash flow. This is Net Profit, less payments on liabilities that are on the Balance Sheet. The lower the ratio, the better a company’s position is to repay its debt. The target is to pay off all debt in 5 years.
To calculate, take your total debt divided by the annualized free cash flow to determine the number of years.
Your target is 1 or greater.
Debt to Total Assets Ratio
A measure of the portion of the business’s assets that are financed through debt. You want more assets you own outright than those you finance. Assets here would include cash, cash equivalents, inventory, accounts receivable, and fixed assets.
To calculate, divide your total debt by your total assets.
Target is less than 50%
Interest Cover
Measure of your ability to service your interest payments from the profits earned by the company. If your income is seasonal, you would need to have your higher-income months at a higher ratio to compensate for your slower months, so that you average 2 or more over the year.
To calculate, take your Net Profit and divide that by Interest Expense minus Interest Income.
The target is anything over 2
Operating Cash Flow to Current Liabilities Ratio
This is a measure of how well your current liabilities are covered by cash flow generated by your operating activities. This will show whether you can pay your short-term liabilities. Cash Flow shows whether you have the actual cash to pay your liabilities, not just the company’s profit.
To calculate, take your annualized operating cash flow divided by your total current liabilities.
Your target is a 1:1 ratio of Cash Flow to Liabilities.
Operating Cash Flow to Debt Ratio
This assesses your ability to pay all your debts, not just your liabilities, over the next year. Will your company be able to cover the total current debt with cash from operations? The higher the result, the better positioned the company is to service its total debt.
To calculate, take your Annualized Operating Cash Flow and divide it by your total debt, then multiply by 100 to get a percentage.
The target is at least 20%; a range of 30-40% would be ideal.
Before taking on any new debt, spend several months reviewing three or four of these metrics to ensure it’s the right move for your company.
If you are looking for more help with your debt ratios or are considering taking on more debt, please feel free to reach out to us here at Waterford Business Solutions. You can call us at 864-351-0852 or send an email to info@waterfordbusines.com.
Additional Resources
For previous videos in our debt series, please see (Please insert link to YouTube video “Debt with your company-is it good or bad?”) as well as (Please insert link to YouTube video “When does debt turn into a debt cycle?”)
For a more in-depth look at debt ratios for small businesses, please see https://beancount.io/blog/2026/01/13/understanding-debt-ratio-guide-for-small-business.
