Following the bursting of the housing bubble and subsequent financial crisis, debt has become somewhat of a 4-letter word to many Americans. And while there are many benefits to debt-free living for households, in the corporate world, debt is often desirable.

The Benefits of Debt

In order for a company to grow, it must finance that growth. This can come from retained earnings, issuing debt, or by selling new shares of stock. While many investors seem to prefer debt-free balance sheets, there are actually quite a few benefits for a company to have some debt:

Too Much of a Good Thing…

Of course too much debt can be crippling for a company if business turns south. The more debt financing a company uses, the greater its risk of bankruptcy.

If a company is distressed, you can bet that those interest payments will get sent out before any dividend checks. And in the event of a bankruptcy, debt holders have first claim on company assets over stockholders.

So what’s the right balance of debt and equity for a company? Ideally, a company should operate around its optimal capital structure – where its weighted average cost of capital (WACC) is minimized. But finding the right amount of debt-to-equity may be more art than science.

There are ways, however, for investors to tell if a company is carrying too much debt. And that involves looking at various financial ratios.

Liquidity vs. Solvency

Two of the best types of ratios to consider are liquidity and solvency ratios.

Liquidity is a measure of the firm’s ability to meet its short-term obligations. Solvency is a measure of the firm’s ability to meet its long-term obligations. It’s more of a measure of the firm’s long-term survival.

One of the most common liquidity ratios is the Current Ratio. This compares a company’s short-term assets to its short-term liabilities: Current Assets / Current Liabilities. The higher the current ratio, the greater a firm’s ability to pay its bills as they come due.