Debt ratio: formula and explanation

tang90246/iStock via Getty Images

What is the debt ratio

The debt ratio is a financial ratio used to determine the extent to which companies rely on leverage to finance their operations. Also called a rate of endettementthe The debt ratio takes into account all debts held by a company, including all loans and bond debts, and all assets, including intangible assets.

If the ratio, which shows debt as a percentage of assets, is greater than 1, it indicates that the company owes more debt than it has assets. This could mean that the business poses a higher risk to investors or lenders, especially if the debt has a variable interest rate and interest rates rise. A lower ratio indicates that a company is less dependent on debt and is financing a larger portion of its assets with equity. This may indicate that the business is more financially stable.

Key point to remember: A high debt-to-equity ratio indicates that a company is highly leveraged and highly dependent on debt to fund its operations.

Debt to Asset Ratio Formula and Calculation

The formula for calculating the debt ratio is simple:

Debt to Assets Ratio = Total Debt / Total Assets

All the information needed to calculate the debt ratio can be found on a company’s balance sheet. The Assets section lists all current and non-current assets. The Liabilities section lists all liabilities and long-term debt of the business and the totals of assets and liabilities are shown. To calculate the ratio, divide total debt by total assets.

Consider the balance sheet below:

Balance sheet

Assets

Species

$267,971

Accounts Receivable

5,100

Inventory

7,805

Property and Equipment

45,500

Total assets

$326,376

Passives

Accounts payable

$3,902

Debt

100,000

Total responsibilities

$103,902

Equity

Equity

$247,474

Retained earnings

2,474

Equity

$172,474

Total Liabilities and Equity

$326,376

The balance sheet shows $326,376 in total assets and $100,000 in total debt. The calculation of the debt-to-asset ratio is as follows:

Debt ratio = $100,000 / $326,376 = 0.306395 = 31%

The debt ratio indicates that the company finances 31% of its assets with debt.

Understanding the Debt Ratio

Essentially, the debt-to-equity ratio is a measure of a company’s financial risk. Investors and lenders rely on the debt-to-equity ratio to gauge a company’s risk of insolvency. Companies with a high ratio are more indebted, which increases the risk of default.

Lenders may be hesitant to lend to companies with already high debt-to-equity ratios and, if they do, it would likely be at a higher interest rate than they would charge companies with already high debt-to-equity ratios. debt is low. This stands to reason, since lending to a company with a high debt ratio suggests a greater risk of recovering the loan, should the company become insolvent.

Additionally, highly leveraged companies can experience financial difficulties when interest rates rise, making it increasingly difficult to generate positive returns on equity, invest in future growth and maintain bonds. debt.

A debt ratio greater than 1 means that a company’s debt exceeds its assets. This amount of leverage could increase potential earnings, but would also be considered a highly leveraged position with a high risk of default. A ratio below 1 means that a company has more assets than debt, giving it the ability to meet its debts by selling its assets if necessary and allowing it to take on more debt if a problem arises. or an opportunity presented itself. Companies with a low debt ratio are considered more financially stable and less risky for investors and lenders.

As with other financial ratios, the debt ratio must be considered in context. It can be assessed over time to determine if a company’s overall risk is improving or worsening and it should be assessed in the context of the specific industry.

For example, companies in capital-intensive industries, such as utilities, airlines, and telecommunications, must invest heavily in infrastructure, supplies, and equipment to deliver their goods or services. For these companies, a high debt ratio may be necessary for growth.

Industries with lower debt ratios, such as services and wholesalers, tend not to have a lot of assets to operate. Companies in more volatile sectors such as technology also tend to operate with less debt and lower ratios.

Key point to remember: High leverage ratios in themselves may or may not represent a serious problem and should be considered relative to historical levels as well as relative to other companies in the same industry. In capital-intensive industries such as airlines, a high debt ratio is considered the norm.

Debt to Asset Ratio Example

Here is a comparison of the debt ratios of three companies:

Rate of endettement

Company

ST debt

Long-term debt

Assets

Debt/Assets

Company X

100

300

900

44.4%

Company Y

0

100

868

11.5%

Company Z

225

900

1,050

107.1%

Company X’s debt ratio is less than 44.4%, which means that it finances its operations mainly with assets. He would probably be able to get additional funding if needed. At 11.5%, Company Y’s ratio is very low compared to the other companies and would be considered the least risky of the three from a debt perspective. Company Z’s ratio of 107.1%, meaning it owes more debt than it has assets, means that investors and lenders would likely view this company as high risk.

However, all conclusions drawn from this comparison may not be entirely accurate without considering the business context. For example, if the three companies belong to three different sectors, it makes little sense to compare them directly. It is also important to consider what stage of the business cycle a company is in. Growth-stage companies may take on more debt to expand their operations or acquire another company to better support a high ratio.

It is also important to take into account the temporal context and the evolution of the debt ratios of companies, whether they improve or deteriorate, to draw conclusions about their financial situation.

Important: TThe debt ratio is less effective as an apples-to-apples comparison between companies of different sizes, in different industries and at different stages of growth.

Conclusion

The debt ratio is used to calculate the share of a company’s assets financed by debt. A high ratio indicates a company that uses debt to gain leverage and relies heavily on leverage to finance its operations. While this may, in part, be a feature of its industry, it may present a higher risk of insolvency for investors and lenders.

Sallie R. Loera