What Is a Debt Ratio?
The debt ratio is 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 portion of debt is funded by assets. In other words, the company has more liabilities than assets. A high ratio also indicates that a company may be putting itself at risk of default on its loans if interest rates were to rise suddenly. A ratio below 1 translates to the fact that a greater portion of a company’s assets is funded by equity.
- The debt ratio measures the amount of leverage used by a company in terms of total debt to total assets.
- A debt ratio greater than 1.0 (100%) tells you that a company has more debt than assets.
- Meanwhile, a debt ratio less than 100% indicates that a company has more assets than debt.
- Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries such as the technology or services sector.
The Formula for the Debt Ratio Is
Debt ratio=Total assetsTotal debt
What Does the Debt Ratio Tell You?
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.
Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries such as the technology sector. For example, if a company has total assets of $100 million and total debt of $30 million, its debt ratio is 30% or 0.30. 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. The fracking industry, for example, experienced tough times beginning in the summer of 2014 due to high levels of debt and plummeting energy prices. 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 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.
Some sources define the debt ratio as 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, but uses total liabilities in 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 lending and mortgages business, 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 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, in percentage terms, ranging from the mid-30s to the low-40s.
Examples of the Debt Ratio
Let’s look at a few examples from different industries to contextualize the debt ratio. Starbucks (SBUX) listed $0 in short-term and current portion of long-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 were $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 should consider the capital expenditures that go into opening a Starbucks: 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, etc. for more than 27,000 locations, in 75 countries (as of 2017). Perhaps 27% isn’t so bad after all, and indeed the industry average was about 66% in 2017. 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 December 31, 2016, Facebook (FB) reported its short-term and current portion of long-term debt as $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 from the corporate bond market. It has an easy enough time raising capital through stock.
Finally, let’s look at a basic materials company, the St. Louis-based miner Arch Coal (ARCH). For the fiscal year ended December 31, 2016, the company posted short-term and current portions of 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 is forgiving of leverage: the average debt ratio was 61% in 2016. Even in this cohort, Arch Coal’s debt ratio of ($11 million + $351.84 million) ÷ $2.14 billion = 16.95% is well below average.
The Difference Between the Debt Ratio and the Long-Term Debt to Asset Ratio
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.
Frequently Asked Questions
What are some common debt ratios?
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 ratios and gearing ratios.
What is a good debt ratio?
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.
What does a debt to equity ratio of 1.5 indicate?
A debt to equity ratio of 1.5 would indicate that the company in question has $1.5 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 1.50.
Can a debt ratio be negative?
If a company has a negative debt ratio, this would mean that the company has negative shareholder equity. In other words, the company has more liabilities than assets. In most cases, this is considered a very risky sign, indicating that the company may be at risk of bankruptcy.
View more information: https://www.investopedia.com/terms/d/debtratio.asp