What are the implications of high debt-to-equity ratios for your company's credit rating?

1 Credit rating basics

A credit rating is an assessment of a company's creditworthiness, or its ability to repay its debts and obligations on time and in full. Credit rating agencies, such as Standard & Poor's, Moody's, and Fitch, assign ratings to companies based on various factors, such as their financial performance, industry outlook, competitive position, and debt level. A higher credit rating indicates a lower risk of default, and vice versa. A credit rating can influence a company's cost of borrowing, access to capital markets, and reputation among investors and customers.

2 How high D/E ratios affect credit ratings

A high D/E ratio can have a negative impact on a company's credit rating, because it indicates that the company has a high debt burden and a low equity cushion. This can make the company more vulnerable to changes in interest rates, cash flows, and market conditions, and reduce its financial flexibility and resilience. A high D/E ratio can also signal that the company has a high dividend payout ratio, which means that it distributes a large portion of its earnings to shareholders, leaving less for debt repayment and reinvestment. Credit rating agencies may lower a company's rating if they perceive that its high D/E ratio poses a threat to its solvency and sustainability.

3 How credit ratings affect your company

A lower credit rating can have a range of adverse consequences for your company, such as higher interest rates, reduced access to capital, and a damaged reputation. Specifically, lenders may charge a higher interest rate to compensate for the potential loss of default, which can increase your company's cost of debt and reduce its profitability and cash flow. Moreover, a lower credit rating can limit your company's ability to raise funds from the capital markets, thus restricting growth opportunities and competitive advantage. Additionally, it can damage your company's reputation among investors, customers, suppliers, and regulators, which can affect market value, customer loyalty, supplier relations, and regulatory compliance.

4 How to manage your D/E ratio

Managing your debt level and capital structure strategically is essential to avoiding the negative effects of a high D/E ratio on your credit rating. To do this, you should monitor your D/E ratio regularly and compare it with industry peers and benchmarks. Aim for a D/E ratio that is in line with your business goals, risk appetite, and growth prospects. If your debt level is too high or unsustainable, you can reduce it by increasing equity through retained earnings or issuing new shares, or by decreasing debt through repayment or refinancing. Conversely, if your debt level is too low or inefficient, you can increase it by taking advantage of low interest rates or tax benefits, or by leveraging debt to fund profitable investments or acquisitions. Finally, you should strive to balance your debt and equity mix to optimize your cost of capital and return on equity by selecting the appropriate sources and types of debt and equity for your company.

5 How to improve your credit rating

Managing your D/E ratio is not the only way to improve your credit rating. To demonstrate your creditworthiness and reliability to the credit rating agencies and the market, you can focus on improving your financial performance and stability by increasing revenue, profitability, cash flow, and liquidity and reducing expenses, volatility, and cyclicality. Additionally, you should enhance your competitive advantage, market share, customer base, and innovation while adapting to the changing trends, demands, and regulations in your industry. Lastly, you should strengthen your board of directors, management team, internal controls, and risk management while disclosing your financial information, strategies, and policies clearly and accurately.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?