The term debt ratio refers to a financial ratio that measures the extent of a company’s leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company’s assets that are financed by debt. A ratio greater than 1 shows that a considerable amount of a company's assets are funded by debt, which means the company has more liabilities than assets. A high ratio indicates that a company may be at risk of default on its loans if interest rates suddenly rise. A ratio below 1 means that a greater portion of a company's assets is funded by equity.
As noted above, a company's debt ratio is a measure of the extent of its financial leverage. This ratio varies widely across industries. Capital-intensive businesses, such as utilities and pipelines tend to have much higher debt ratios than others like the technology sector.
The formula for calculating a company's debt ratio is: Debt ratio = Total debt Total assets \begin{aligned} &\text{Debt ratio} = \frac{\text{Total debt}}{\text{Total assets}} \end{aligned} Debt ratio=Total assetsTotal debt
So if a company has total assets of $100 million and total debt of $30 million, its debt ratio is 0.3 or 30%. Is this company in a better financial situation than one with a debt ratio of 40%? The answer depends on the industry. A debt ratio of 30% may be too high for an industry with volatile cash flows, in which most businesses take on little debt. A company with a high debt ratio relative to its peers would probably find it expensive to borrow and could find itself in a crunch if circumstances change. Conversely, a debt level of 40% may be easily manageable for a company in a sector such as utilities, where cash flows are stable and higher debt ratios are the norm.
A debt ratio greater than 1.0 (100%) tells you that a company has more debt than assets. Meanwhile, a debt ratio of less than 100% indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's risk level.
The fracking industry experienced tough times beginning in the summer of 2014 due to high levels of debt and plummeting energy prices. Some sources consider the debt ratio to be total liabilities divided by total assets. This reflects a certain ambiguity between the terms debt and liabilities that depends on the circumstance. The debt-to-equity ratio, for example, is closely related to and more common than the debt ratio, instead, using total liabilities as the numerator. Financial data providers calculate it using only long-term and short-term debt (including current portions of long-term debt), excluding liabilities such as accounts payable, negative goodwill, and others. In the consumer lending and mortgage business, two common debt ratios used to assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and the total debt service ratio.
The gross debt ratio is defined as the ratio of monthly housing costs (including mortgage payments, home insurance, and property costs) to monthly income, while the total debt service ratio is the ratio of monthly housing costs plus other debt such as car payments and credit card borrowings to monthly income. Acceptable levels of the total debt service ratio range from the mid-30s to the low-40s in percentage terms.
The higher the debt ratio, the more leveraged a company is, implying greater financial risk. At the same time, leverage is an important tool that companies use to grow, and many businesses find sustainable uses for debt. While the total debt to total assets ratio includes all debts, the long-term debt to assets ratio only takes into account long-term debts. The debt ratio (total debt to assets) measure takes into account both long-term debts, such as mortgages and securities, and current or short-term debts such as rent, utilities, and loans maturing in less than 12 months. Both ratios, however, encompass all of a business's assets, including tangible assets such as equipment and inventory and intangible assets such as accounts receivables. Because the total debt to assets ratio includes more of a company's liabilities, this number is almost always higher than a company's long-term debt to assets ratio. Let's look at a few examples from different industries to contextualize the debt ratio. Starbucks (SBUX) listed $998.9 million in short-term and current portion of long-term debt on its balance sheet for the fiscal year ended. Oct. 3, 2021, and $13.6 billion in long-term debt. The company's total assets were $31.4 billion. This gives us a debt ratio of $14.6 billion ÷ $31.4 billion = 0.465, or 46.5%. To assess whether this is high, we should consider the capital expenditures that go into opening a Starbucks, including leasing commercial space, renovating it to fit a certain layout, and purchasing expensive specialty equipment, much of which is used infrequently. The company must also hire and train employees in an industry with exceptionally high employee turnover, adhere to food safety regulations for its more than 17,133 stores in 2022. Perhaps 46.5% isn't so bad after all when you consider that the industry average was about 75% in 2022. The result is that Starbucks has an easy time borrowing money—creditors trust that it is in a solid financial position and can be expected to pay them back in full. What about a technology company? For the fiscal year ended Dec. 31, 2021, Meta (META), formerly Facebook, reported:
Using these figures, Meta's debt ratio can be calculated as ($14.45 billion) ÷ $170 billion = 0.085, or 8.5%. The company does not borrow from the corporate bond market. It has an easy enough time raising capital through stock.
All debt ratios analyze a company's relative debt position. Common debt ratios include debt-to-equity, debt-to-assets, long-term debt-to-assets, and leverage and gearing ratios.
What counts as a good debt ratio will depend on the nature of the business and its industry. Generally speaking, a debt-to-equity or debt-to-assets ratio below 1.0 would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky. Some industries, such as banking, are known for having much higher debt-to-equity ratios than others.
A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Since equity is equal to assets minus liabilities, the company’s equity would be $800,000. Its debt-to-equity ratio would therefore be $1.2 million divided by $800,000, or 1.5.
If a company has a negative debt ratio, this would mean that the company has negative shareholder equity. In other words, the company's liabilities outnumber its assets. In most cases, this is considered a very risky sign, indicating that the company may be at risk of bankruptcy.
Debt ratio is a metric that measures a company's total debt, as a percentage of its total assets. A high debt ratio indicates that a company is highly leveraged, and may have borrowed more money than it can easily pay back. Investors and accountants use debt ratios to assess the risk that a company is likely to default on its obligations. |
Identify which of the following formulas correctly defines how to calculate the debt ratio.
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