The Debt ratio is an important indicator for lenders and stockholders. It indicates the level of a company’s debt against its assets. It’s usual for businesses to offer loans and debts on asset based collateral. However, both lenders and stockholders would be interested to know the company’s level of financing against their assets. So how to calculate debt ratio?
Before going into detail, let’s go through the basic definition of debt ratio.
What is Debt Ratio?
The Debt ratio is also known as debt to assets ratio. The debt ratio is the value of a company’s debt financing against its assets. It is calculated in absolute terms usually. It defines the leverage level of a company. Unlike the gearing ratio, it compares the debt financing against the company assets and not the equity.
How to Calculate Debt Ratio?
As it is a measure of assets against debt financing, we can calculate debt ratio in different ways depending on the analysis of asset or debt nature.
Below is the basic debt ratio formula:
Debt Ratio = Total Debt / Total Asset
A variation of the debt ratio can be used including the current assets or long-term debt against fixed or long-term assets. However, including all forms of debt against total assets provides a comprehensive leverage position of the business.
Let us consider a real world example to understand the debt ratio. For the year ending 2019, Facebook Incorporation reported total assets of $ 133,374 million. Their Total liabilities less than the shareholders’ equity represent the debt financing, which remained at $ 32,322 million.
Then, we can simply calculate Debt ratio as follow:
Debt Ratio = 32,322 ÷ 133,374 = 0.24 times
It can be calculated in percentage terms as 24%.
For the current year 2020, Facebook incorporation half yearly reports suggest the following figures.
Total Assets = $ 139,691 Total Debts = $ 29,244
The recent debt ratio becomes,
The Debt ratio = 29,244 ÷ 139,691 = 0.20 times or 20%
Interpretation and Analysis
Any financial ratio alone cannot provide useful information. As we have seen in our working example, the debt ratio for Facebook has reduced from 0.24 to 0.20 or from 24% to 20%.
What does it tell though? Does it depict an improvement? Or a reduction in debts?
A general rule of thumb with the debt ratio is to keep it below 1.0 or 100%. It implies that a firm’s debt financing is secured against assets. A ratio above 1.0 or 100% would mean the company has secured more debt than its underlying assets.
Lenders will be particularly interested in understanding the debt ratio trends for the company. A higher debt ratio means, in case of a default the company would be unable to repay the liabilities against assets.
A too low debt ratio would concern the shareholders too. As it implies the company has underutilized the cheaper financing options of debt. Debt financing is considered cheaper than equity financing, which brings the total cost of capital down.
A comprehensive analysis of a debt ratio would include the information comparison against other important leverage indicators. Along with the debt ratio, the company’s D/E and total gearing can also provide useful information. The debt furnishing ability of a company can also be compared against industry standards.
Debt ratio analysis will also differ with industry analysis. A company with long-term assets and operating high cash flows having a debt ratio of above 50% will be considered too high. On the other hand, a company in a business with less cash flow having a debt ratio of 80% can be deemed safe.
Another way of understanding the debt financing of a company is to interpret the trends of company performance over the years. As in your working example, the debt ratio for Facebook Inc. has reduced from 24% to 20%. It depicts two things, the company has reduced the debts and the assets have increased the worth. Both of these indicators are positive. However, a smaller company in the same industry may not enjoy the cash flows as Facebook Inc. and may have to depend on higher debt financing.
Who Uses the Debt Ratio Analysis?
At a glance, the debt ratio will provide the leverage of a company to the lenders. As the banks and other investors look for collateral against loan financing. A higher debt ratio above 80% would leave a little room for lenders to offer further financing facilities against the already pledged assets.
For equity stockholders, the debt ratio analysis would usually concern about the balance between debt and equity financing. A too high debt ratio would also concern the investors as it poses a default risk, which ultimately will bring stockholders wealth in danger. A too low debt ratio will also not please the stockholders as it will increase the total cost of capital.
Both lenders and stockholders would like an optimum debt ratio. Depending on the industry and company size, a debt ratio of around 50% will be deemed safe for any ratio analysis.
Importance of Debt Ratio Analysis
If the debt ratio is interpreted with historical information of the business or industry trends it can offer valuable analysis.
- It offers a simple and straight forward analysis that can be understood easily by management and investors alike
- It provides insights on company leverage position in simple terms
- A high debt ratio means the company has financed more against the assets, a lower ratio means the company has financed more with equity
- It provides useful industry comparison and historical performance measure of the company debt and leverage position
Limitations of Debt Ratio
A common limitation of any ratio analysis is it cannot be interpreted against a single value.
- The historical data used in ratio analysis can change quickly and make the ratio analyses obsolete
- Without trend analysis or industry comparison debt ratio analysis does not provide useful information
- It needs to be interpreted in conjunction with other gearing and leverage ratios for comprehensive analysis
The debt ratio along with D/E and Debt service ratios can provide useful information for both lenders and stockholders. It offers insights into the company leverage position as well as debt financing against assets. It can provide useful analysis on a company default risk at a glance. However, a standalone ratio cannot reveal the full picture. The debt ratio should be compared with industry standards and the historical trends of the company.