What is debt ratio?
A company’s debt ratio is a solvency ratio that tells us what percentage of its assets consist of debt. It measures the extent of a business’ leverage. The calculation can also be used to determine the extent of a consumer’s (individual’s) leverage. This is one of several financial ratios that managers, investors, creditors and analysts use to determine a company’s health.
The ratio can be expressed as a decimal figure or a percentage (more commonly as a percentage).
Debt Ratio = Total Debt ÷ Total Assets.
Total debt (total liabilities) means all current plus long-term liabilities, while total assets are the sum of current assets, plus fixed assets, as well as all other assets such as ‘goodwill’. ‘Goodwill’ is a company’s established reputation – it is a quantifiable asset, i.e. it is worth money, and is calculated as part of its total value.
Debt ratio levels differ from industry to industry. What may seem a healthy ratio in one industry might not be the case in another.
Debt ratio shows a business’ ability to clear its debts by using its assets, or how many assets it must sell in order to pay off all its liabilities. Lenders and creditors closely monitor this measurement when deciding whether or not to offer loans to businesses and individuals.
According to Cambridge Dictionaries Online, debt ratio is:
“A measurement of a company’s ability to borrow money and pay it back, that is calculated by dividing the total amount of all kinds of debt that is owed by the amount that shareholders have invested. This method can be used by investors to decide whether or not to invest in a company.”
At national level, the term refers to the ratio of government debt to GDP (gross domestic product).
Example of debt ratio
Imagine a company, John Doe Inc., has $50 million of debt on its balance sheet and $100 million of assets.
John Doe’s debt ratio is:
Debt Ratio = $50m ÷ $100m = 0.50 or 50%.
This means that for every dollar in John Doe’s assets, it has $0.50 of debt.
A ratio of less than 100% (<1) means the company has more assets than debts, while a figure greater than 100% (>1) means it has more debts than assets.
Why is debt ratio important?
This type of ratio tells us how deeply in debt (leveraged) a business is, which contributes to determining its measure of risk.
Companies with a high debt ratio are carrying a bigger burden in the sense that interest and principle payments take a large amount of their cash flows. This means that a sudden rise in interest rates or an unexpected dip in financial performance could lead to default.
When the debt ratio is low, on the other hand, interest and principal payments do not represent such a large portion of the firm’s cash flows, which means it can better withstand sudden spikes in interest rates or hiccups in financial performance.
If the ratio is very low, however, it might suggest that the company should take more advantage of leverage to boost growth.
Debt ratios and industries
Debt ratios vary considerably from industry to industry. Car rental companies, which have lots of assets (cars), and finance the purchase of their vehicles with debt, generally have a high debt ratio.
A technology company like Google, for example, does not need a lot of physical assets to sell its products, and thus tends to have very low debt ratios.
When analyzing a business’ debt ratio, it is important to compare it with other companies in the same sector.
This term should not be confused with the debt service coverage ratio (DSCR), which is the ratio of available cash to cover the servicing of interest, principal and lease payments.
Video – Debt ratio explained
In this InvestingAnswers video, Sara Glakas, Chief Investment Strategist, explains debt ratio and gives us some examples of how the formula works and why different industries have higher or lower ratios.