What is a Debt Ratio?

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Definition:

Debt ratio measures a company’s debt compared to its total assets — an indication of the level of financial risk of a company.

🤔 Understanding debt ratio

A company’s debt ratio indicates how much debt it’s using to fund purchases of assets and can be expressed as either a decimal or percentage. The higher the debt ratio, the more the company is relying on borrowing to finance assets. The lower the debt ratio, the greater the percentage of the assets the company actually owns. Analysts, investors, and creditors often use the debt ratio to assess the overall financial risk of the company. Companies with a high debt ratio may have more difficulty paying back current loans and securing new ones. On the other hand, companies with a low debt ratio have more cash and assets available to service their debts. The interpretation of debt ratios varies across industries and should be viewed over a period of time to track changes.

Example

Let’s take a look at Twitter’s total assets and total liabilities on the balance sheet for the quarter that ended in September 30, 2019:

Total Assets: \$11,600,925,000 Total Liabilities: \$3,185,283,000 Debt Ratio: \$3,185,283,000 / \$11,600,925,000 = 0.27 (Source: Twitter Quarterly Reports)

The debt ratio shows that Twitter used 27 cents in loans to purchase one dollar of assets. The lower the debt ratio, the less the company relies on external financing to finance operations.

Takeaway

A debt ratio is like a canary in a coal mine…

Historically, when a canary passed away in a coal mine, the miners would know it was time to make a quick exit. The bird served as a measure of risk, but it was up to the miners to make a decision. Likewise, the debt ratio indicates the level of financial risk from a company to firm stakeholders, but it’s up to them to make a move.

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What is the debt ratio?

The debt ratio indicates what percentage of total company assets were acquired with debt. Just like you may take out a loan to purchase a car, a company can seek financing to buy machinery and other types of assets. The debt ratio indicates what portion of the assets are not fully owned by the shareholders and could be claimed by lenders.

The higher the debt ratio of a company, the higher its degree of leverage — aka company use of debt to finance the purchase of assets. When a company has too much leverage, it holds higher financial risk as it may have a harder time paying back its current loans and getting approved for new ones.

How do you calculate debt ratios?

The formula to calculate the debt ratio is:

For public companies, you can find the total liabilities and total assets in the company’s balance sheet. Make sure that you’re comparing “apples to apples” in order to get an accurate picture. Select numbers that are totals (not just short-term or long-term), for the same time period (e.g., total assets as of December 31, 2019, and total liabilities as of December 31, 2019), and are in the same units (e.g., both figures reported in millions).

What are some examples of the debt ratio?

Let’s take a look at two examples: one in the car manufacturing industry and another in the tech industry.

Debt ratio in the car manufacturing industry

In Q3 2019, General Motors (GM) reported total assets of \$231,529M and total liabilities of \$182,758M in its consolidated balance sheet. (Source: General Motors Quarterly Reports)

By dividing the total liabilities by the total assets, you obtain a debt ratio for GM of 0.79 or 79%. In other words, GM used 79 cents of debt to finance the purchase of one dollar of assets.

Debt ratio in the tech industry

In that same quarter, Square reported total assets of \$4,000 and total liabilities of \$2,750M in its consolidated balance sheet. (Source: Square Quarterly Reports)

Divide the total liabilities by the total assets to see that Square’s debt ratio is 0.69 or 69%. Square used 69 cents of debt to finance the purchase of one dollar of assets.

What does the debt ratio tell you?

A debt ratio is a snapshot of a company's balance sheet at a specific point in time. It tells you how much of the assets are financed with debt and signals the potential risk of a company running into a “cash crunch.”

Keeping all things the same, a company with a debt ratio of 0.25 would generally have less financial risk than a company with a debt ratio of 0.90. The company with the 0.90 debt ratio has a high degree of leverage and needs to be able to produce more revenue to pay creditors. On the other hand, the company with a 0.25 debt ratio has assets available that it can sell to cover its debt payments if it can’t produce enough revenue.

Here are three useful rules of thumb to evaluate a debt ratio:

• Debt ratio under 1: The company has a higher percentage of assets than liabilities, so it has a potential “rainy day fund” to cover its financial obligations. The company is typically considered to have low to moderate financial risk.
• Debt ratio of 1: All of the company assets are financed with debt. The company is highly leveraged and likely considered to have a high financial risk.
• Debt ratio over 1: The company has more liabilities than assets. The company is extremely leveraged and generally considered to have very high financial risk.

What is a good debt ratio?

A good debt ratio follows the Goldilocks principle — not too big, not too small, but just right. However, what is considered “just right” varies by industry and needs to be put into context by considering change over time, industry average, and other applicable factors.

Let’s consider the following scenarios:

• In the first quarter of 2020, a fictitious company has a debt ratio of 0.85, which may seem high. However, the company’s debt ratio used to be 0.90 in the fourth quarter of 2019 and 0.92 in the third quarter of 2019. By lowering its debt ratio over the last three quarters, the company is indicating lower financial risk.
• Another fictitious company has a debt ratio of 0.30, which may be considered low. However, if the industry average for that company were 0.18, the company would be considered highly leveraged in relation to its peers.
• As of June 30, 2019, Microsoft reported total assets of \$286,556M and total liabilities of \$184,22M, resulting in a 0.64 debt ratio for Microsoft. While there may be other tech companies with lower debt ratios, the Microsoft corporate credit rating is AAA by Standard & Poor’s Rating Services. Microsoft is one of the only two companies in the entire U.S. that holds this top corporate credit rating — Think of this score as an 850 FICO credit score for companies.

Why is the debt ratio important?

The debt ratio is important because it provides context to the company's sustainability, financial health, and overall performance. If you were to focus only on the revenue of a company and those revenues are increasing year after year, you may think that the company is doing well. However, if those revenues aren’t generating enough cash flow to meet monthly debt payments and pay down total debt, then investing in the company may involve higher financial risk than expected.

Ratio analysis of financial statements using the debt ratio and other financial formulas is important because it allows you to have a more comprehensive picture of a company and make better-informed investment decisions.

What is the long-term debt ratio?

The long-term debt ratio only focuses on long-term debt. Unlike the debt ratio, the long-term calculation doesn’t take into account short-term company debts, such as a net 30 account payable or an equipment loan maturing in six months. The long-term debt ratio generally refers to debt with a maturity of 12 months and more.

The formula to calculate the long-term debt ratio is:

Long-term liabilities / total assets = long-term debt ratio

The debt ratio is higher than the long-term debt ratio unless the company has no short-term debts in its balance sheet. When the company has no short-term debts, the ratios are equal.

What is the difference between debt to equity and debt ratio?

The difference between debt to equity and the debt ratio is that the debt to equity ratio doesn’t involve total assets. The debt to equity ratio instead calculates a company’s debt compared to its shareholder’s equity. This helps illustrate what percentage of the company is owed to creditors versus owned by shareholders.

The formula to calculate the debt to equity ratio is:

Total liabilities / shareholders’ equity = equity ratio

What is the current ratio?

The current ratio signals the ability of a company to meet its short-term obligations (due within 12 months) with its “current assets” — assets that can be sold and turned into cash within 12 months.

The formula to calculate the current ratio is:

Current assets / current liabilities = current ratio

In addition to the debt ratio, the current ratio is another useful financial ratio to evaluate the financial risk of a company.

What is the debt to asset ratio?

The debt to asset ratio is another term used to refer to the debt ratio. It’s a more descriptive phrase because it explicitly states that the ratio calculation involves assets. In ratio analysis, you'll often find a ratio that you can refer to in different ways.

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