Credit Utilization vs. Debt Ratio: Which Is More Important?

Credit utilization measures the financial health of a business by assessing how much credit is being used compared to what’s available. Lenders often consider credit utilization, which is also called “debt utilization,” when determining a credit score, which is good since it’s one of the easier metrics to control.

Still, credit utilization is only one component of debt to consider: if you’re a business owner looking for funding options, it’s important to understand debt ratio, too.

A business’s debt ratio compares the relationship between total liabilities and total assets and is seen as an indicator of how dependent a business is on debt to finance its operations. The formula for debt ratio is total debt (how much you owe) divided by total assets (how much you own). 

DEBT RATIO = TOTAL DEBT / TOTAL ASSETS

This metric aims to determine how risky a borrower is by looking at the overall solvency of their business. A high debt ratio, for example, arises when the total “owed” is far greater than total “owned.”

Defining Credit Utilization

In contrast, credit utilization is the percentage of revolving credit a business chooses to use relative to the total credit it has available (used or not).

CREDIT UTILIZATION = CREDIT USED / TOTAL CREDIT AVAILABLE

Credit utilization is more frequently referred to as your credit utilization rate (CUR) and is frequently expressed as a percentage.

Say, for example, your business has $100,000 in credit accessible via credit cards and a business line of credit, but is only using $20,000 of that credit. That would indicate a ratio of 20,000/100,000, which simplifies to 1/5 or a 20% credit utilization rate. Or, if you have 3 business credit cards with $100,000 limits on each and have used $75,000 across all the cards, your credit utilization rate would be 25% ($75,000/$300,000 = 25% credit utilization ratio). 

Why Is Credit Utilization Important for Businesses?

A business’s credit or debt utilization ratio demonstrates how potentially risky a borrower is from a lending perspective. This information affects lenders’ confidence in a borrower and can directly impact that borrower’s loan terms and qualification status. 

FICO, one of the leading credit scoring models, weighs credit utilization as the second-most important factor (30%) behind only payment history (35%). VantageScore, another credit modeling rating from Experian, also values credit utilization highly.

What Is a Good Credit Utilization Rate (CUR)?

You may have seen advice known as the 30% credit utilization rule, which basically states that you should try not to exceed a CUR of 30% when they’re seeking financing. Sometimes, however, exceeding a 30% utilization rate may be unavoidable. For example, if your business recently invested in new equipment or used a credit card to cover short-term expenses, you may have a higher-than-normal credit utilization ratio.

A 2020 consumer credit survey from Experian found that the average credit utilization rate was 25.8%. However, if you want to significantly improve your business credit score and increase your loan approval odds and access more favorable terms, you should aim for a utilization rate below 10%.

A Debt Utilization Ratio of 0% Is Not the Goal

Here’s where things get tricky: a lower credit utilization ratio is better in the eyes of lenders because it makes a business appear more responsible as a borrower—but a 0% debt utilization rate isn’t the target, since it provides lenders little insight into spending habits.

Jim Droske, president of Illinois Credit Services, told CNBC, “When a credit card account is reported with a zero balance, some scoring models will look at a zero balance as if the card is not being used.”

Even though 0% is better than an excessively high rate, targeting somewhere between 1 – 9% is closer to ideal, since debt usage can actually demonstrate responsible spending habits and increase the odds of favorable loan terms.

How to Improve Your Credit Utilization Ratio

If your credit utilization ratio is higher than you’d like, there are things you can do to help improve it, including the following:

• Pay off your outstanding debts quickly: One of the easiest ways to lower your credit utilization ratio is to pay down the credit you owe.
• Increase your credit limit: You can also improve your ratio by increasing your credit limit—although this might hurt your score for other reasons.
• Consolidate into installments: Credit utilization rates look at revolving lines of credit; consolidating your debts into a loan which you pay off with installments can help lower your utilization ratio.

Debt is a powerful tool for businesses both small and large. Whether you’re incurring debt to help scale your operations or needing to pay on credit to weather the slow season, debt is often integral to running a successful business. However, it’s always a good idea to keep an eye on your credit utilization ratio and work towards lowering it into the optimal 1 – 9% range, which can improve financing options and long-term financial stability, too.

Disclaimer: The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.