Debt ratio – definition and meaning
Debt ratio is a solvency ratio that tells us what percentage of a company’s assets consist of debt. Debt ratios measure the extent of a business’ leverage. We also use the calculation to determine the extent of a consumer’s leverage. Consumer, in this context, means individual people.
This is one of several financial ratios that managers, investors, and analysts use to determine a company’s health. Creditors also use it for the same reason.
We can express the ratio as a decimal figure or a percentage.
Debt Ratio = Total Debt ÷ Total Assets
Total debt means all current plus long-term liabilities. Instead of total debt, we can say total liabilities.
Total assets are the sum of current assets, plus fixed assets, as well as all other assets. For example, ‘goodwill’ is an asset. ‘Goodwill’ is a company’s established reputation – it is a quantifiable asset. In other words, it is worth money, and we calculate it as part of the total value of assets.
Who monitors debt ratio?
Debt ratio shows us how well a company can clear its debts by using its assets. Alternatively, it tells us how many assets a company must sell to pay off all its liabilities. Lenders closely monitor this measurement when deciding whether to offer loans.
Suppliers also look at a companies debt ratios when deciding whether to offer trade terms.
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.”
At national level, the term refers to the ratio of government debt to GDP. GDP stands for 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. On the other hand, a figure greater than 100% (>1) means it has more debts than assets.
Why is debt ratio important?
This ratio tells us how deeply in debt a business is. Its depth of leverage contributes to determining a company’s measure of risk. In this context, ‘leverage’ equals ‘debt.’
Companies with a high debt ratio are carrying a bigger burden. Their burden is bigger because interest and principal payments take a large proportion of their cash flows. Consequently, 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, the burden is smaller. In other words, interest and principal payments do not represent such a large portion of the firm’s cash flows. Therefore, it can better withstand sudden spikes in interest rates or economic downturns.
If the ratio is very low, however, it might suggest that the company should take more advantage of leverage. In other words, it should borrow more to boost growth.
Debt ratios and industries
Debt ratios vary considerably from industry to industry. Car rental companies, which have lots of assets, have a high debt ratio. Their main assets are cars. Car rental companies finance the purchase of their vehicles with debt.
A technology company like Google, for example, does not need a lot of physical assets to sell its products. Therefore, tech companies have comparatively low debt ratios.
When analyzing a business’ debt ratio, it is important to compare it with other companies in the same sector.
Do not confuse this term with the debt service coverage ratio (DSCR). DSCR which is the ratio of available cash to cover the servicing of interest, principal, and lease payments.
Video – Debt ratio
In this InvestingAnswers video, Sara Glakas explains debt ratio and gives us some examples of how the formula works. She tells us why different industries have higher or lower ratios.