Ratio analysis: the debt ratio
Turning to leverage ratios, Axel Tracy presents the debt ratio to the readers of “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyze Any Business on the Planet”.
Leverage is the use of borrowed money to increase the return on an investment. For example, if we can borrow at 5% and invest that money in stocks that pay 10%, then we have doubled our earning capacity. We leveraged our existing investment.
Of course, leverage can also backfire and amplify our losses rather than increasing them. So we need to carefully analyze the use of debt, and one of the metrics we use for that is the debt ratio. Tracy wrote: “This is both a solvency risk ratio and a strategy ratio, as it can also be viewed as the level of a company’s debt-financed assets. . He added: “Simply put, it measures the level of liabilities to assets and is expressed as a percentage.”
Because it is shown as a percentage and not as an absolute number, it can be compared from one company to another. It also shows what would be left to owners if all assets were sold and all debts paid off. Strategically, the debt ratio tells us what percentages of assets have been financed by debt and equity.
The formula is:
“Debt ratio = Liabilities / Assets”
Data for both liabilities and assets come from the balance sheet.
GuruFocus does not provide a debt-to-debt ratio reading, but does provide a similar measure, the debt-to-income ratio (which we’ll talk about in a future article). While the debt ratio is defined as the liability divided by the asset, the debt ratio is defined as the liability divided by equity. GuruFocus’ debt ratio can be found in the financial strength section of the summary page; in this example it is for 3M (MMM, Financial):
Coming back to the debt ratio, Tracy reminded us that it is expressed as a percentage, and a ratio of 65%, for example, means that 65% of the company’s assets have been financed by debt. It also means that the company owes 65 cents of debt for every dollar of assets.
The debt ratio also measures risk; if the level of debt increases or decreases, the level of risk changes with it. More debt = more risk. Generally, a lower debt ratio is considered better because the business is more secure and the risks of bankruptcy are reduced. When there are more assets than debts, there is good reason to believe that the financial position of the company is strong.
Two factors affect the debt ratio: lower or higher debt and lower or higher asset values. There are many ways to reduce debt; one method is to increase sales and use part of the income or profit to speed up debt repayment. The value of assets can be increased by means such as using a portion of sales or higher profits to purchase new, better equipment. Of course, such a proposition only makes sense when the cost of debt is not greater than the cost of assets.
Tracy also emphasizes that one should be wary of a debt ratio above 100%. He wrote: “On the negative side, if the profit is more than 100%, then in theory the company could not pay off all of its debts even if it sold every one of its assets. This is a negative point both for the creditors and for the company itself.
An important criticism of the debt ratio is that it is too broad a measure. For example, it does not deal with smaller segments of assets and liabilities such as current and non-current assets or liabilities. The debt ratio cannot take into account the fact that a company may have mostly long-term debt and therefore is not at risk.
Another criticism is that the debt ratio is based on book value, which may be different from fair value. Tracy compares this with homeowners who want to sell their homes quickly and are forced to drop the price below fair value to get an immediate sale. He added, to put it mildly, “This is why using the debt ratio to tell us how much would be left for owners or tell us how easily a business could pay off all of its debt, may not be 100% accurate. .
The debt ratio, as described by Tracy in “Ratio Analysis Fundamentals How 17 Financial Ratios Can Allow You to Analyze Any Business on the Planet,” is a useful measure, but one that should be used with caution.
It tells investors a story, but not the whole story. The basic story is the relationship between a company’s debts and its assets, the leverage that the company uses to accelerate its revenues and profits.
The “full” story, the larger perspective, is that debt is determined by company policy, and all company policies reflect a unique set of goals, conditions, and conditions. business practices.
Disclosure: I do not own any shares in any listed company and do not expect to buy any in the next 72 hours.
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