Debt ratio is a financial ratio representing the ratio of external financing (total liabilities and provisions) to total assets and is used in the analysis of the capital structure.
It determines the extent to which the company is funded by external financing and to which by its own capital. This financial indicator is very often used in practice. The essence of the Debt-to-Assets Ratio suggests that it reflects the degree of financial leverage. Nevertheless, it should be remembered that this concept is very broad and there are many other methods that are used to determine it.
How to Calculate the Debt Ratio?
The Debt Ratio is calculated by dividing Total Debt by Total Assets. These numbers are found in the balance sheet.
Debt\; Ratio = \frac{Total\; Debt}{Total\; Assets}The structure of the ratio shows that the higher the value of the ratio, the higher the share of external financing in funding the company’s assets. Having a high level of debt involves the risk of insolvency, i.e. an excessively indebted company, at some point may lose its ability to pay back the borrowed funds.
Interpretation of the Debt Ratio
In short, the higher the value of the ratio, the higher the company’s debt and, consequently, the greater is the risk associated with this investment.
High levels of the Debt Ratio (above 0.5) signify a large share of debt in the company’s capital structure and thus the risk of insolvency, debt spiral, serious financial problems or even bankruptcy in case of economic downturn. Of course, the large values of the ratio do not immediately exclude the investment opportunity, but they are a signal that the investment is not very secure. In companies with the extremely bad economic and financial situation, the debt ratio reaches a value greater than 1.
Low levels (less than 0.5) of the Debt Ratio demonstrate the company’s financial strength and ability to finance its activities and assets. A higher ratio may be a proof of the company losing the ability to pay its obligations, a lower ratio – irrational management of funding sources.
Every industry is characterized by a certain specificity of the capital structure. High debt level can be quite natural in some types of business. Therefore, the value of the debt ratio should be compared with the industry average or other competitors, like all financial ratios. It is also important to examine the changes in the value of the ratio over several periods and to try to identify the trends.
Benefits of Using a Financial Leverage
The use of financial leverage allows for faster implementation of certain projects and increasing the scale of operations. Financial leverage allows the company to achieve an above-average economic effect by partly financing business activities with borrowed capital. An alternative is to raise capital from the investors and stockholders, but it may be a long-term process. Taking into account the benefits of using leverage, as well as the risk associated with having a higher debt, there is a certain optimal and desired result, which is different for each industry, but in some literature the acceptable level of involvement of debt in financing the company’s assets is in the range of 0.5-0.6.
Example of the Debt Ratio Calculation
A company plans to implement a new project, which expected to be profitable, but it needs to buy some equipment. The company reaches to a bank, to borrow additional funds. The bank examines the company’s debt levels.
The company has $600,000 of assets and $200,000 of liabilities.
Debt\; Ratio = \frac{\$200,000}{\$600,000} = 0.3The Debt Ratio is significantly below 0.5, which signifies the company is financially strong and is able to pay its debts. The Ratio of 0.3 means that the company has $3 of assets for each $1 of debt. The bank approves the loan.