Debt Ratio

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Debt ratio is a measurement that indicates how much leverage a company uses to finance its operation by using debt instead of its truly owned capital or equity. The ratio does this by calculating the proportion of the company’s debts as part of the company’s total assets. This is the combination of total debts and total equity.

As mentioned, total assets are the culmination of total equity plus liabilities, both long-term and short-term. If debts incorporate the larger part of a company’s assets, it means that the company has a higher risk to no longer be able to meet its financial obligations or insolvency. On the contrary, companies that has higher equity percentage among assets are comparably better at managing the risk in order to fulfil the assets requirements and avoid bankruptcy at the same time.

The debt ratio is one of many tools investors or creditors use to gauge how much leverage a company uses to improve its capital or assets in the hope of gaining more profits. The debt ratio can also be referred to as the debt to asset ratio. Both of these ratios have the same formula.

Debt Ratio Formula

Debt\: Ratio =\dfrac{Total\: Liabilities}{Total\: Assets}

To determine the debt ratio, we will need to know the total liabilities (debt) and total assets. These values can be easily found on the balance sheet. Total debts can also be obtained by subtracting equity—also known as shareholders’ equity—from total assets. Total liabilities needs to include both short-term debts and long-term debts.

A company with a high debt ratio is using more debts than equity. This means a majority of the company’s assets come from borrowed capital. These companies believed that in exchange for taking more risks, they could generate more income and be more profitable in the long run. Ideally, companies should not unwittingly incur too many debts or take on unnecessary ones. These can result in detrimental consequences.

In different circumstances, corporations that are using fewer debts are less risky as they’re adopting a more conservative approach to their business. Not only that, but investors are also relatively more attracted to these businesses since the risks are more manageable. Alternatively, potential lending institutions such as banks are also more inclined to prolong their credit. These companies have a higher chance of continuing to meet their payment duty on time.

The debt ratio can be expressed as either decimal or percentage. Simply multiply the result of the equation to 100% to make it a percentage. Companies with a debt ratio of less than 50% are often preferred by creditors and inventors. With that said, to get a more accurate result, it may be a good idea to compare the debt ration of the company in multiple periods to check for consistencies.

Debt Ratio Example

An investor named Sandra wishes to know if a utility company she interested in is a good candidate to put her money on. Sandra decided to use the debt ratio of the company from last year’s results as one of the bases of her decision. She can determine the company’s total assets to be $13,000,000 after looking at the company’s balance sheet she obtained. She also found out that the company the combined amount of short-term debts and long-term debts of $3,900,000. Can we calculate the company’s debt ratio based on this data?

Let’s break it down to identify the meaning and value of the different variables in this problem.

  • Total liabilities: 4,900,000
  • Total assets: 13,000,000

We can apply the values to our variables and calculate the debt ratio:

Debt\: Ratio =\dfrac{4{,}900{,}000}{13{,}000{,}000} = 0.3769

In this case, the debt ratio would be 0.3769 or 37.69%.

From the result above, we can see that the utility company has taken the somewhat conservative approach of not using too much leverage to finance the assets. This can be concluded from the less than than 50% of the debt ratio. In this case, Sandra can be more rest assured investing in this company even if for some reasons the company may not do well.

Debt Ratio Analysis

The debt ratio can tell us how dependent a company is to debt. Some businesses use leverage as a strategy to have more potential earning, by using loaned money to boost resources while also incurring more risks. Whether a debt ratio of a company is too high or too low depends on the industry it operates. Companies with stable cash flows such as pipelines or utility companies tend to have a higher debt ratio on average. In contrast, technology companies that has more volatile cash flows tend to have a lower debt ratio.

Leverage measurement ratios such as debt ratio are often used by lenders and investors to indicates how safe financially a company is. These candidates of capital donors will more likely go for companies that rely on equity or shareholders’ equity—the capital they truly own. Lenders are more willing to put their money on the company while investors will have an easier time sleeping at night in the period of financial adversaries.

A low debt ratio is a signal indicating that the company is managing its risks wisely. It will most likely able to pay off its due debts on time. A low debt ratio will also reduce the likelihood of bankruptcy or the inability state of business to pay its debts resulting in a legal proceeding with its lenders. Besides, a lower debt ratio also serves as a prevention measure in case lenders decided to up their interests.

With that said, an extremely low debt ratio—compared to the competitors in the same industry—does not always hint that the company is effectively managing its business. A very low debt ratio indeed means fewer risks involved. However, the lack of funds the company has may hinder it to grow the way it potentially should. The company may struggle to run its business activity effectively and receive less return as a result. To gain maximum profits, investors should look for a company that aims for the same thing while also does not neglect risks.

Debt Ratio Conclusion

  • The debt ratio indicates how much leverage a company uses to supply its assets using debts. Debt ratio is the same as debt to asset ratio and both have the same formula.
  • The formula for debt ratio requires two variables: total liabilities and total assets.
  • The results of the debt ratio can be expressed in percentage or decimal.
  • The amount of a good debt ratio should depend on the industry.
  • Lower debt ratios can offer financial protection.
  • If a debt ratio is too low, companies wouldn’t use debt as a tool for growth.

Debt Ratio Calculator

You can use the debt ratio calculator below to quickly determine the leverage a company uses to supply its assets using debts by entering the required numbers.