Definition of debt ratio
What is the debt ratio?
The debt ratio is a financial ratio that measures the extent of a company’s indebtedness. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal number or as a 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 part of the debt is financed by assets. In other words, the business has more liabilities than assets. A high ratio also indicates that a company may be exposed to a risk of default on its loans if interest rates were to rise suddenly. A ratio less than 1 means that more of a company’s assets are financed by equity.
Key points to remember
- The debt ratio measures the amount of leverage used by a business in terms of total debt over total assets.
- A debt ratio above 1.0 (100%) means a business has more debt than assets, while a debt ratio below 100% means a business has more assets than debt. .
- Debt ratios vary widely from industry to industry depending on the capital intensity of the industry.
The debt ratio formula is
Rate of endettement=Total assetsTotal debt
What does the debt ratio tell you?
The higher the debt ratio, the more indebted a company is, which implies greater financial risk. At the same time, leverage is an important tool that businesses use to grow, and many businesses are finding sustainable uses for debt.
Debt ratios vary widely across industries, with capital-intensive companies such as utilities and pipelines having much higher debt ratios than other industries such as the tech sector. For example, if a business has total assets of $ 100 million and total debt of $ 30 million, its debt-to-equity ratio is 30% or 0.3. Is this company in a better financial situation than a company 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 flow, in which most companies have little debt. A business with a high debt ratio relative to its peers would likely find it expensive to borrow and could end up in dire straits if circumstances change.
The hydraulic fracturing industry, for example, went through tough times starting in the summer of 2014 due to high debt levels and falling energy prices. Conversely, a debt level of 40% can be easily manageable for a business in an industry like utilities, where cash flow is stable and debt ratios are the norm.
A debt ratio greater than 1.0 (100%) tells you that a business has more debt than assets. Meanwhile, a debt ratio of less than 100% indicates that a business has more assets than debt. Used in conjunction with other measures of financial health, the debt-to-equity ratio can help investors determine how risky a business is.
Some sources define the debt ratio as total liabilities divided by total assets. This reflects a certain ambiguity between the terms “debt” and “liability” which depends on the circumstances. The debt ratio, for example, is closely related and more common than the debt ratio, but uses total liabilities as the numerator. In the case of the debt ratio, 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 “other”.
In the consumer loan and mortgage industry, two common debt ratios that are used to assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and the debt ratio. total debt service.
The gross debt ratio is defined as the ratio of monthly housing costs (including mortgage payments, home insurance, and real estate costs) to monthly income, while the total debt service ratio is the ratio of monthly housing costs plus other debts such as car payments and monthly income credit card loans. Acceptable levels of the total debt service ratio, in percentage terms, range from the mid-30s to the low 40s.
Examples of debt ratio
Let’s look at some examples from different industries to contextualize the debt ratio. Starbucks (SBUX) recorded $ 0 in short-term and short-term debt on its balance sheet for the fiscal year ended October 1, 2017 and $ 3.93 billion in long-term debt. The company’s total assets stood at $ 14.37 billion. This gives us a debt ratio of $ 3.93 billion ÷ $ 14.37 billion = 0.2734, or 27.34%.
To assess whether this is high, we need to take into account the capital expenditure required to open a Starbucks: leasing commercial space, renovating it to fit a certain layout, and purchasing equipment. expensive specialists, most of which are rarely used. The company must also hire and train employees in an industry with exceptionally high turnover, comply with food safety regulations, etc. for its more than 27,000 sites in 75 countries in 2017. Maybe 27% isn’t that bad after all, and indeed the industry average was around 65% in 2017. The result is that Starbucks can easily borrow money; creditors are confident that she is in a sound financial position and can be expected to pay them back in full.
What about a tech company? For the year ended December 31, 2016, Facebook (FB) reported its short-term portion and long-term debt of $ 280 million; its long-term debt was $ 5.77 billion; its total assets were $ 64.96 billion. Facebook’s debt ratio can be calculated as ($ 280 million + $ 5.7 billion) ÷ $ 64.96 billion = 0.092, or 9.2%. Facebook does not borrow in the corporate bond market. It is quite easy for him to raise capital through stocks.
Finally, let’s take a look at a basic materials company, the St. Louis-based mining company Arch Coal (ARCH). For the year ended December 31, 2016, the company posted short-term and short-term long-term debt of $ 11 million, long-term debt of $ 351.84 million and total assets of 2 , $ 14 billion. Coal mining is extremely capital intensive, so the industry forgives debt: the average debt ratio was 61% in 2016. Even in this cohort, Arch Coal’s debt-to-equity ratio of ($ 11 million + $ 351.84 million) ÷ $ 2.14 billion = 16.95% is well below average.
Debt ratio vs long-term debt / asset ratio
While the ratio of total debt to total assets includes all debt, the ratio of long-term debt to assets only takes into account long-term debt. The debt-to-asset ratio measure (total debt to assets) takes into account both long-term debt, such as mortgages and securities, and current or short-term debt such as rents, utilities and loans with a maturity of less than 12 months. Both ratios, however, encompass all of a company’s assets, including tangible assets such as equipment and inventory and intangible assets such as accounts receivable. Because the total debt-to-assets ratio includes a larger portion of a company’s liabilities, this number is almost always greater than a company’s long-term debt-to-assets ratio.
What are the common debt ratios?
All debt ratios analyze the relative debt position of a company. Current debt ratios include debt-to-equity ratios, debt-to-assets, long-term debt-to-assets, and debt-to-debt ratios.
What is a good debt ratio?
What counts as a “good” debt to equity ratio will depend on the nature of the business and its industry. Generally speaking, a debt-to-equity or debt-to-asset ratio of less than 1.0 would be considered relatively safe, while ratios of 2.0 or more would be considered risky. Some industries, such as banking, are known to have much higher debt ratios than others.
What does a debt ratio of 1.5 indicate?
A debt to equity ratio of 1.5 would indicate that the business in question has $ 1.50 in debt for every $ 1 of equity. As an example, suppose the business has assets of $ 2 million and liabilities of $ 1.2 million. Since equity equals assets minus liabilities, the equity of the business would be $ 800,000. Its debt ratio would therefore be $ 1.2 million divided by $ 800,000, or 1.5.
Can a debt ratio be negative?
If a business has a negative debt ratio, it would mean that the business has negative equity. In other words, the company’s liabilities outnumber its assets. In most cases, this is considered a very risky sign, indicating that the business may be in danger of bankruptcy.